Maximum Employment and Monetary Policy

The maximum employment objective of the Fed’s dual mandate requires a yardstick against which to compare actual labor market performance, but devising such a yardstick is not a simple process. The long-run rate of unemployment — the level to which unemployment converges over time in the absence of economic shocks and under appropriate monetary policy — could be a misleading benchmark since it does not consider variations in economic conditions. The natural rate of unemployment — which takes into account unanticipated disturbances in the economy, the time it takes to adjust to those shocks and the frictions that affect the pace of adjustment — may be a better benchmark for the Fed to judge whether it is achieving maximum employment. Monetary policy is simply unable to offset all of the ways in which various frictions impede the economy’s adjustment to various shocks. Estimating the natural rate of unemployment is difficult because of the precision required to measure the shocks that drive the economy’s behavior over time and the frictions that govern the economy’s response. Therefore, you must spell out the model used to estimate those shocks and frictions in order for others to judge your assessment. In principle, the natural rate of unemployment could be close to the long-run unemployment rate, but generally these rates will differ, especially following significant economic disruptions like the Great Recession. There are several impediments to more rapid growth that are likely to have increased the natural rate of unemployment and, therefore, lengthened the journey back to the long-run unemployment rate: (1) the housing market is still coping with a large inventory overhang; (2) the reallocation and skill mismatch frictions have affected labor markets at a relatively high level; (3) policy uncertainty has seriously dampened investments and hiring for new business ventures. The FOMC’s recent decisions to start a new asset purchase program, lengthen its “forward guidance” regarding monetary policy and purchase additional agency mortgage-backed securities were tough calls, debated fully and amiably by Committee members, but they may prove problematic.