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Slow Employment Recoveries, Monetary Policy, and Expected Inflation

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.

Postwar Payroll Employment Cycles

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.

Target Federal Funds Rate

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 a 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.

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.

Core PCE Vintages

The most recent policy episode has been the most extreme of the three, reflecting the worst recession since the Great Depression. As a consequence, the fed funds rate was reduced to almost 0 percent in December 2008 and has been held there since. What is unique about this recent experience is that policy easing was constrained by the zero lower bound.  To address this constraint, the FOMC adopted several innovative policies, including the large-scale asset purchase program (LSAP). This is uncharted territory, however, leaving many policy analysts concerned that policy will be too accommodative for too long. April’s policy announcement suggests that current policy is expected to persist until late 2014.

Clearly on the employment side, employment growth remains subpar and justifies continuation of the accommodative policy stance. On the inflation front, however, some policy analysts are concerned that the recent sharp rise in oil prices, in conjunction with the accommodative policy stance, could lead to a potentially sharp increase in inflation down the road.

One particularly policy-relevant indicator developed at the Cleveland Fed is the 3-year, 2-year forward expected inflation rate. This measure looks two years ahead and estimates what the average annual inflation rate is expected to be over the subsequent three years. For example, the 3-year, 2-year forward expected inflation rate for April 2012 estimates the average annual inflation rate from April 2014 to April 2017. This indicator is relevant to policy for two reasons. First, monetary policy actions are known to operate on inflation with a lag of roughly two years. Second, the inflation goal of the FOMC is meant to be achieved over the long-run, so inflation should be examined over a period of time longer than one year.

Target Federal Funds Rate and Expected Inflation

Examining the 3-year, 2-year forward expected inflation rate and the federal funds rate together, one can see a very rough relationship between the two measures. This co-movement should not be surprising, as mandate-consistent monetary policy would imply that deviations in inflation expectations from the inflation goal would require corrective policy actions.

The increase in expected inflation that started in 1994 was accompanied by a similarly large increase in the fed funds rate. This was also true of the rate increases that began in 2004. In both cases, the increase in the fed funds rate was preceded by the increase in inflation expectations as well. This suggests that the federal funds rate increases that began in 1994 and 2004 were as least partly justified by this inflation indicator. Currently, one can clearly see that the trend in the policy-relevant inflation expectation measure continues to decline well after the recession. The expected inflation series seems to see oil-induced inflationary pressures as temporary, and further suggests that current policy does not pose a threat of an imminent acceleration in inflation.

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