QE2: In pursuit of full employment?

In the statement following the final FOMC meeting for 2010, Chairman Bernanke cited growth was insufficient to bring down unemployment and confirmed the disinflationary forces facing the US economy. This statement negates decades of debate that price stability was the Fed’s primary and overriding goal. Evident from the unprecedented measures the committee has taken over the last thirty six months, promoting stable prices and ‘maximum sustainable output and employment’ appears to be of equal importance.

Admittedly, the economic data reported since the start of the year has been significantly better than expected. Unfortunately, two major headwinds continue to challenge the domestic economy. US household net worth continues its decline forcing consumers to save more of their disposable income and rebuild their net worth. Banks with poor asset quality are still playing defence. Many have chosen to preserve capital ratios by limiting asset growth and expansion of their loan books. This unavailability of credit to small businesses and entrepreneurs limits their ability to hire, and fuels a negative employment cycle.

But given the rhetoric from Fed governors on inflation and unemployment, one could build a case that the current direction seems to favour unemployment as the driving force behind the committee’s recent policy actions.

Achieving full or the natural rate of employment is much easier said than done! Fundamentally, an economy will always have some level of frictional or structural unemployment due to the mismatch between workers and skills, or changing dynamics in hiring efficiencies.

There are also many differing opinion amongst economists on the true rate of natural unemployment. According to the Federal Reserve Bank of San Francisco, full employment occurs when all available labour resources are being used in the most economically efficient way. A much preferred and proven gauge of measuring this metric is the non-accelerating inflation rate of unemployment, which considers the unemployment rate when inflation is stable.

Alban William Phillips, a New Zealand economist, purported the theory of the Phillips Curve. On the face of it, this theory appears quite intuitive. It describes an inverse relationship between the unemployment rate and wage inflation. It asserts that wages increase slowly when the unemployment rate is high and more rapidly when the unemployment rate is low, inferring that high levels of unemployment results in low levels of wage inflation, at least in the short term.

Now consider that there are more than 14.5 million Americans actively looking for employment, another 8.9 million people are employed part-time due to economic reasons but are interested in full time employment. There is another 2.6 million marginally attached to the labour force but have become discouraged in looking for work, and millions more are crossing the border legally or illegally looking for work. The number of people willing to work is fast approaching 30 million!

John Maynard Keynes, another renowned economist who became popular following the Great Depression in the 1930s, developed an associated theory based on the circular flow of money. Keynesians advocate that active government intervention in the market place and monetary policy is the best method to ensuring economic growth and stability.

It is no secret that Ben Bernanke is a scholar of the Great Depression and firmly fits within the Keynesian camp. Combining the Phillips Curve (whether short term or inflation augmented) with Keynesian economics, policy makers are betting on its monetary policies to influence employment in the short term at the risk of inflation. By stimulating the economy, it is hope that inflation will revert back to its targeted 1.5 per cent – 2 per cent range while employment increases to a level consistent with longer term prosperity.

While economic theories are still at odds as to whether monetary policy can lead to any sustainable increase in employment, empirical evidence suggests the ideal balance between employment and inflation are yet to be determined. For now, we can only hope that in navigating this uncharted territory, the FOMC will strike a successful balance between ‘stimulus with discipline’ and ‘excessive stimulus’ or we will continue to sail blindly past the Rock of Gibraltar to the wide open world beyond.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.