The Fed’s Forward Guidance: Prioritizing Labor Markets to Ensure a Robust Recovery For All

by Alex Williams and Skanda Amarnath

The Fed’s recent forward guidance on its zero interest rate policy (ZIRP) was a welcome sign that the Fed’s monetary policy strategy is giving appropriate emphasis to the achievement of sustainably tight labor markets. While there remains room for improvement, we highlight four welcome takeaways from the September FOMC meeting worth celebrating and building upon.

#1: Exiting ZIRP is necessarily preconditioned on achieving tight labor markets, and not just on achieving its 2% inflation target.

We have argued elsewhere that, while the Evans Rule was a success, its original form presented many opportunities for improvement. The Fed’s mandate is to pursue maximum employment and price stability, not maximum employment or price stability. While we would prefer that a wage or income indicator be used in place of inflation, the commitment to dual conditionality helps ensure that the liftoff of interest rates will not come before the labor market has had ample opportunity to make a full recovery.

#2: Not just lower unemployment, but maximum employment.

In the years since the Evans Rule — and against a backdrop of steadily falling unemployment — officials at the Fed declared again and again that the economy had gone “beyond full employment.”

In late 2019 and early 2020, we saw strong wage growth among the lowest income-earners, an increase in the quit rate, and finally a full recovery in the prime-age employment-population ratio from its pre-financial crisis peak…without ever seeing core inflation rise sustainably to its 2% target, let alone runaway inflation. The robust labor market and muted inflation of that era demonstrates that if a tradeoff between inflation and unemployment does in fact exist, then it binds at a much lower unemployment rate than previously believed.

Judging by the September meeting, FOMC members are no longer taking such an ultra-hedged approach to setting labor market thresholds for interest rate forward guidance. The Fed isn’t just aiming for a lower unemployment rate, but for an achievement of its estimate of maximum employment. While the Fed rightly evaluates maximum employment on multiple measures, the only measure outside observers can rely on is the estimate of the longer run unemployment consistent with the Fed’s dual mandate objectives. The median of FOMC members’ estimates was 4.1% both in December 2019 and 4.1% in its most recent release. While estimates of maximum employment may waiver up or down depending on how inflationary labor market progress proves to be, the Fed’s presumption that the pre-COVID labor market is achievable is not only admirable but prudent.

Since the pre-crisis labor market saw unemployment below FOMC members’ estimates of the so-called “natural rate” without inflation consistently reaching 2%, FOMC members should already be skeptical of whether such estimates really serve as a useful lower bound for how low the unemployment rate can sustainably fall. Chair Powell himself has been very critical of these unobservable estimates, most forcefully so in his 2018 Jackson Hole speech. We are glad to see the Fed take on board empirical evidence that the economy can run much hotter than it may have previously assumed.

#3: The Fed is signaling that it may begin using a fuller range of indicators for labor market strength beyond headline U3 unemployment.

Beyond the current estimation problems, the U3 unemployment rate is a surprisingly limited indicator for the strength of the labor market. Wages, bargaining power, and labor conditions are completely left out. Using a single number to collapse all distinctions by race, gender, geography, income level and educational attainment makes it impossible to target any particular subgroup who may be experiencing much worse unemployment than the headline number. At the same time, the U3 measure sharply limits which workers count as members of the labor force. It doesn’t take very long without a job for an economically disadvantaged worker to be counted as “discouraged”, and so left out of the U3 unemployment rate. Given these problems, it is heartening to see that the Fed’s focus on labor market outcomes extends to the use of a wider range of labor market indicators.

We at Employ America look forward to the Fed employing a more robust and holistic approach to understanding labor market conditions. With Chair Powell’s comments about waiting “to see heat,” in the labor market to “call it hot” in mind, we hope to see the Fed make extensive use of wage and income-based indicators like the Employment Cost Index (ECI) and other proxies for gross labor income (GLI). When workers have the power that a tight labor market provides, these indicators will let the Fed know clearly and unambiguously.

At the same time, the Fed needs to make sure that these strong labor markets are pulling in as many workers as possible. Underemployment and persistent long-term unemployment among discouraged workers is a substantial problem carried over from the 2008 financial crisis and the ensuing jobless recovery. To ensure that history doesn’t repeat, Chair Powell has already hinted at using the labor force participation rate as a key indicator. While this would already be a substantial improvement over current practice, we at Employ America would strongly suggest that the Fed shift from the U-3 unemployment rate to a strictly superior labor utilization measure, such as an age-adjusted employment-to-population ratio or Ernie Tedeschi’s demographic-adjusted NPOP measure.

If FOMC members transparently translate their views about maximum employment to indicators other than the U-3 unemployment rate, the Fed would substantially improve the quality of their communication and dialogue with the public.

#4: While we would prefer it applied directly to wage growth, the Fed’s affirmative floor for inflation readings can function similarly in achieving wage growth.

In light of the presence of the zero lower bound and serially below-2% inflation outcomes, the Fed may be analytically correct to address the underperformance of inflation. At the same time, continuing to cast the Fed’s goal specifically in terms of inflation does present some risks. As a purely rhetorical matter, an affirmative promise to achieve higher inflation is likely to be received by the public more negatively than an affirmative promise to achieve higher wage growth. The Fed is politically independent, but it does not operate in a political vacuum.

Inflation indices also roll together a number of economic forces with no clear relation or consistency — commodities, rents, labor costs, exchange rates, the terms of cell phone data plans — and treats them as a straightforward barometer for gauging the adequacy of income and credit creation. Depending on the source of inflationary forces, the Fed could easily find itself distracted by noise — changes in hedonic adjustment methodology, temporary supply chain strains, commodity price adjustment — over signal. Even if the Fed itself is focused on the factors that drive the underlying trend in inflation, including wages and rents, it will prove to be a communication challenge for external observers to understand whether the Fed views the achievement of its 2% target to be a sustainable achievement.


We write, crunch #’s, and tweet about the labor market and economic policy.