Magazine article Economic Trends

Slow Employment Recoveries, Monetary Policy, and Expected Inflation

Magazine article Economic Trends

Slow Employment Recoveries, Monetary Policy, and Expected Inflation

Article excerpt

04.25.2012

Since the early 1990s, employment growth has been persistently slow coming out of recessions. This phenomenon, often described as a "jobless" recovery, has become increasingly severe over the past two decades, posing new challenges for monetary policy. Achieving maximum employment, along with price stability, is one of the two policy objectives mandated by Congress for the Federal Reserve.

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Not surprisingly, the jobless recovery phenomenon has prompted somewhat unprecedented interest rate policies from the Fed. These policies have been characterized by long periods of constant and increasingly lower levels of the federal funds rate following each of the last three recessions.

Each of the low-interest-rate periods has posed unique challenges for the communication of policy actions, especially at the onset of policy tightening. It is useful to review some key attributes that characterize the three policy episodes.

Just prior to and following the previous three recessions, the Fed aggressively lowered interest rates and held the fed funds rate at a low level for a period of several months. The recession in 1990-1991 induced a decline in the fed funds rate from over 9 percent to 3 percent, where it remained for 17 months. That stretch of 3 percent interest rates came to a sudden end in February 1994, when market participants were surprised by 50 basis point increase in the fed funds rate. Bond prices fell sharply after investors failed to anticipate the Fed's series of policy firming moves, which were deemed necessary to contain inflationary pressures.

During and after the 2001 recession, the Fed also reduced the fed funds rate significantly, this time from 6.5 percent to 1 percent. The 1 percent interest rate was held for an entire year. Given the surprise the markets experienced in 1994, the Federal Open Market Committee (FOMC) introduced forward-looking language in its policy statements prior to the first firming move to reduce the potential for a disorderly surprise.

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Many analysts have criticized the FOMC for keeping interest rates too low for too long during this episode. One factor that misled policymakers during this period was the FOMC's preferred measure of underlying inflation. The Fed had adopted the core PCE as its key measure of inflation, but estimates of PCE inflation are subject to revisions, and in this case the revisions were quite substantial. As a result, the FOMC was gauging its policy actions on measures that suggested inflation rates were lower and falling faster than the subsequently revised numbers now indicate. Perhaps had policy firming been initiated sooner, the housing market bubble would have been less severe and less damaging to the economy.

The most recent policy episode has been the most extreme of the three, reflecting the worst recession since the Great Depression. …

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