Research published Tuesday by the Federal Reserve Bank of Cleveland argues that central banks facing a surprise drop in the number of available workers should take a cautious, rather than aggressive, approach in tightening monetary policy, even if that means tolerate a period of higher inflation.
This provides a new perspective as Federal Reserve officials ponder how much to raise interest rates. The authors note that the United States suffered a severe labor supply shock in 2020 when the pandemic hit and that conventional wisdom dictates that policy tightens to cool demand for workers to offset the hit on inflation.
While a tighter policy would cool demand for goods and labor, an even smaller labor force would boost wage growth and inflation more than it would have been under “optimal” policy, the authors said.
“We find that cyclical changes in labor force participation call for a less restrictive policy response to a decline in labor supply,” wrote Takushi Kurozumi, associate managing director of the Bank of Japan, and Willem Van Zandweghe, an economist at the Fed. Cleveland.
They based their findings by adapting standard economic models to include the possibility of workers being able to leave and re-enter the workforce, more closely reflecting what happens in a real economy.
“Optimal policy overturns the conventional wisdom that central banks can and should fully offset the inflationary effects of such a shock, obtained in textbook models that abstract from labor force inflows and outflows,” they wrote.
Fed officials are rapidly raising interest rates to curb the highest inflation in nearly four decades and have said this is aimed directly at reducing overheated demand for labor. But the key question of where rates peak and how long they should stay there remains a matter of debate.
Central bankers are also pinning their hopes on a soft landing for the economy, in which unemployment does not rise too much while inflation subsides, on the idea that some people who dropped out due to covid concerns will return to the labor market.
Officials are due to meet Sept. 20-21 and have put another 75 basis point hike on the table, following two such moves in June and July, or a half-point hike, depending on the data.
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