Fed focus on jobs implies significant inflation overshoot

The US Federal Reserves determination to stimulate the economy  through low interest rates and bond buying until employment returns to  pre-epidemic levels will likely raise commodity prices significantly in  the interim.

Production and employment have fallen much further  below their long-term trends than prices, as a result of the epidemic,  and before that the trade wars with China and other trading partners in  2018/19.

If the central bank is determined to stimulate the  economy until the production and employment gaps have been closed fully,  it will have to accept a significant overshooting in prices compared to  trend.

By targeting parts of the economy that exhibit the most  cyclical slack, the central bank must accept that other parts of the  economy with far less slack will exhibit significant frictional  inflation.

Top officials calculate these price signals will be  temporary and will not become embedded into corporate and household  expectations and price- and wage-setting behaviour.

If they are  correct, wages will experience a one-off fall in real terms. If not,  embedded inflation will require more contractionary monetary and fiscal  policies in future to stop overheating and bring prices back to target.

Estimating  the amount of cyclical slack in the economy as a result of the  epidemic, lockdowns, trade wars and the general business cycle downturn,  is more of an art than a science.

Estimates depend on identifying  a point in the past when the economy was at full capacity utilisation  and employment, an underlying trend growth rate, and then projecting  output, employment and prices forward.

The National Bureau of  Economic Researchs Business Cycle Dating Committee estimates the last  cycle peaked in February 2020, immediately before the first wave of  coronavirus infections hit.

Manufacturing output peaked more than a  year earlier in December 2018, after which the economy started to be  hit by the impact of conflicts with major trading partners and a rise in  policy uncertainty.

Sometime from December 2018 to February 2020  is therefore most likely to correspond to full employment and capacity  utilisation when the unemployment rate was around 3 per cent and the  utilisation rate was 75-78 per cent.

In the five years prior to  December 2018, manufacturing output increased at an average annual rate  of 1.2 per cent, while the number of nonfarm jobs increased by around  1.8 per cent per year.

By December 2019, production had already  fallen 2 per cent below its previous trend, as a result of the trade  wars, and the deficit had widened to 22 per cent at the height of the  first wave of the epidemic and lockdowns in April 2020.

Since then  manufacturing output has rebounded as a result of fiscal and monetary  stimulus, as well as the re-opening of much of the economy, and is now  just 5 per cent below its 2014-2018 trend.

In the labour market,  nonfarm employment is currently 7 per cent below the 2014-2018 trend,  with the deficit slightly worse in services (-7 per cent) and  construction (-7 per cent) and narrower in manufacturing (-6 per cent).

The  loss of employment compared with the previous trend is equivalent to 9  million jobs in services, 800,000 jobs in manufacturing and 600,000 jobs  in construction.

Overall, therefore, output and employment are  about 5-7 per cent below their pre-epidemic trend and probable potential  level, which is the best measure of the gap the Fed is trying to close.

By  contrast, downward pressure on prices has been more modest. The  personal consumption expenditures price index for all items other than  food and energy is less than 1 per cent below its level in December 2018  projected forward at the Feds target increase of 2 per cent per year.

On  the pricing side, the negative deviation from trend is likely to be  closed within the next 3-6 months between July and October.

Negative  deviations in production and employment are likely to take much longer  to close, depending on relaxation of coronavirus controls and the speed  of the business expansion.

The Feds dilemma is that it has only  one instrument (really a suite of inter-related instruments including  short-term interest rates and portfolio adjustments).

With one  instrument, it can only have one primary target, a point made by the  Dutch economist Jan Tinbergen, and known as the Tinbergen rule.

So  the Fed must choose between targeting the negative  production-employment gap, which implies a longer period of stimulus, or  the price gap, which implies a far shorter one.

The Feds public  explanations of its strategy, articulated in press statements and  speeches by policymakers, tend to make confusing remarks about both the  production-employment and price gaps.

Top officials talk about the  need for prices to catch up after a period of below-target increases,  though the target level is unstated, and the evidence for prices being  significantly below trend is limited.

By contrast, Fed actions  show it is primarily focused on closing the production-employment gap,  and prepared to tolerate a degree of overshooting on prices in the  meantime.

In reality, the central bank has no choice, given its  limited range of policy instruments and the different degrees of slack  in different parts of the economy.

But prolonged stimulus through  2021 and into 2022 will ensure the manufacturing supply chain (including  raw materials, freight transportation, warehousing and distribution) is  stretched taut for at least the next 12-18 months.

Prices for raw  materials, transportation and manufactured items will therefore move  above long-term trend levels earlier than usual in this business cycle  as the Fed tries to mop up remaining pockets of unemployment.