FOMCminutes,easymoneyandNAIRU

The minutes of the FOMC meeting which was held on 26^th – 27^th January 2021 were released yesterday. On the expected lines markets parsed through the text of the statement searching for dovish clues which were present aplenty. The committee acknowledged that the economy is improving courtesy of the monetary and fiscal help but the uncertainty regarding the future still remains at elevated levels. Any emergence of new virus strains, resistance to the vaccination program and hiccups in the vaccine rollout can result in the lockdowns again stunting the economic activity. The increase in the price of some items should not be construed as a widespread inflation and should not cause a concern. The generalised inflation should also be allowed to run above the mandated 2% levels for some time to compensate for the ultra-low levels seen in recent times. On the employment side, the reduction in LFPR is a cause for concern as few people have decided to leave the labour force and bringing them back in the employment fold would require continued accommodation of the policy measures.

In the 19 page, 11500 word strong document the following words appeared frequently. Pandemic 39 times, covid 7 times and virus 14 times. Employment occurred 56 and inflation was used 68 times. Risk and uncertainty appeared 29 times and 3 times respectively. The purport of the text is clear that the markets currently have no reasons to worry on the front of policy retraction and they can’t continue to swim in accommodative waters for some time to come.

Now here we will take a small detour to discuss the Fed mandate in a little more detail. Unlike many other central banks, Fed carries a dual mandate of maximum employment and stable long term consumer price inflation around 2%. Our readers would identify that on very basic scrutiny these two goals appear at odds with each other and a very fine balance is required to optimise both goals. Now increase in employment is directly linked to economic activity. An accommodative monetary policy induces industry to borrow and start new businesses. This raises demand for the labour force. Firstly, the currently unemployed find jobs and then secondly the people who have left the labour force also start coming back. If there is still demand left, the currently employed will start asking for a wage increase. This introduces wage inflation and with the higher disposable income in hands, the increased wages lead to more consumption, leading to more demand of goods and services, in turn increasing the prices of the same. The last part is known as the generalised inflation.

What we just saw was the rudimentary sketch of wage inflation feeding into widespread inflation. So, the Fed must know the exact point at which it needs to get off the pedal so as not to stoke high inflation while in search of maximum employment. Hence the two mandates are seemingly at odds. There is a concept called NAIRU or Non-Accelerating inflation rate of unemployment which the Fed employs as a control mechanism. We will discuss the same in our future notes, expanding this point further.