How Will We Know When the Fed Is Ready to Taper?

The U.S. labor market holds the key to the inflation outlook and the timing of the withdrawal of monetary policy accommodation. After all, it is pressure on resources that ultimately leads to persistent inflation. If workers are in chronic short supply, wage inflation climbs and that usually feeds through into prices. In contrast, supply disruptions typically get resolved with time. Businesses respond by reallocating resources. Once this occurs, price pressures abate. In those cases, inflation turns out to be transitory.

The labor market situation is particularly murky at the moment. As the pandemic abates and the economy rebounds, there is no good historical example to use as a benchmark. Moreover, labor market indicators are all over the place, with some indicating lots of slack and others suggesting unprecedented tightness.

On the side of slack, the civilian unemployment rate stands at 5.9%, well above the trough of 3.5% reached in February 2020, right before the start of the pandemic. Similarly, the level of employment — measured by the Labor Department’s household survey — is still about 7 million jobs short of what it was just prior to the pandemic. The shortfall is larger than what’s implied by the unemployment rate gap because the labor force participation rate fell sharply during the pandemic.

The 7 million figure is the measure Fed Chair Jerome Powell likes to cite to demonstrate that there is a still a long way to go before the central bank meets its goal of “substantial further progress” toward maximum sustainable employment. That is an important benchmark because it is the standard that Fed officials have said they need to meet before they begin to taper asset purchases.

On the side of stringency, job openings remain at record highs, with businesses reporting 9.2 million available positions in May, 2 million more than in February 2020. Anecdotal evidence supports the inability of companies to find sufficient workers. The Fed’s latest Beige Book report notes: “The lack of job candidates prevented some firms from increasing output, and less commonly, led some businesses to reduce their hours of operation.” This implies that the economic recovery is being held back by worker shortages.

So which is it? Is the labor market loose or tight?

The answer is both. There are three important factors making it difficult for employers to find workers, but these factors are mostly transitory. As they abate, the labor market is likely to loosen.

First, labor supply has fallen as some potential workers withdrew from the workforce. For example, retirements soared as Covid-19 put older people at particular risk. The Federal Reserve Bank of Dallas estimates that 2.6 million people have retired since the start of the pandemic, about 1.5 million more than would have been expected.

Second, unusually high unemployment compensation benefits are causing some potential employees to sit on the sidelines. The Biden administration’s fiscal stimulus package included a supplemental $300-per-week unemployment compensation benefit on top of what state plans pay. This meant that some lower wage workers could actually earn more by staying unemployed and collecting unemployment benefits.

Third, some parents have decided to stay home to take care of children who have not been able to attend school in person. Earlier, schools were mostly virtual but now it’s summer and they are out of session.

These constraints on the labor supply will almost certainly lessen soon. Some states have already phased out the federal supplemental unemployment compensation benefits. For others, these benefits will end in September. Similarly, schools will be back in session in a few months, allowing students to attend in person. When this happens, the labor force participation rate will rise, more people will go back to work and the number of unfilled job openings will fall. Even the sharp increase in retirees we have seen over the past year may not prove persistent. Some may decide to go back to work as job opportunities become more plentiful and rising wages make it more attractive to return to the workforce. 

So what does this mean for the Fed and monetary policy? For now, it means waiting and watching. The unemployment rate and the size of the employment shortfall suggest there is considerable labor market slack. How much slack exists will come into better focus over the next few months, once the expiration of supplemental unemployment compensation benefits and the reopening of schools have their impacts.

We won’t have a firm grasp on where things stand until early November, which is when the October household and payroll employment reports become available.

This means that Fed officials are unlikely to know whether they have indeed made “substantial further progress” toward maximum sustainable employment until this fall. Until then, they are unlikely to tip their hand about the timing of the asset-purchase taper. However, the Federal Open Market Committee statement language may need adjusting earlier. After all, as progress is made the standard of “substantial further progress” eventually becomes unworkable. At some point, there is no longer room for “substantial further progress.”  

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a Bloomberg Opinion columnist. He is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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