What if the Fed hadn’t made a ‘mistake’? A hypothetical to consider.

Stocks rallied last week, with the S&P 500 rising 3.5%. The index is now up 7% year to date, up 14.9% from its October 12 closing low of 3,577.03, and down 14.3% from its January 3, 2022 closing high of 4,796.56.

Much of the market volatility over the past year can be explained by the Federal Reserve’s ongoing fight to bring down inflation with increasingly tight monetary policy.

The Criticism of the Fed’s Monetary Policy

I’m not one to dwell on the past, but it’s become commonplace for people to blast the Fed for getting monetary policy wrong from the inflation perspective. Many point out that inflation has been stubbornly high because the central bank made a “mistake” by being too slow to remove the stimulative monetary policy.

These critics aren’t necessarily wrong. But assuming the Fed did hit the brakes on the economy when inflation started heating up in 2021, where would we be today?

If such a move worked and inflation eased quickly, then it’s also unlikely the economy would be as strong as it is today. After all, tightening monetary policy is about cooling demand, which means the labor market probably wouldn’t be as robust as it is today.

Would everyone be OK with that?

The Effect on Employment and Inflation

Remember, the number of people who’ve gotten jobs during this period of high inflation is massive. And the money earned by these newly employed people is helping to keep inflation high as they bring more demand into the economy.

As of February of this year, total payroll employment was 155 million. However, this metric didn’t reach its pre-pandemic level of 152 billion until June 2022.

Meanwhile, inflation became particularly alarming in June 2021, when the consumer price index surged above 5% for the first time since 2008. At that time, total payroll employment was much lower at 147 million.

Similarly, as of February, the unemployment rate was a deficient 3.6%. It didn’t initially fall back to the pre-pandemic level of 3.5% until July 2022. In June 2021, when inflation was setting off alarms, it was elevated at 5.9%.

To be clear: This is a discussion about counterfactuals, which means there’s no way to know exactly how things would unfold under alternative scenarios.

But it’s not unreasonable to imagine a world where inflation was closer to the Fed’s target 2% rate today because the central bank acted quickly to rein in demand. This is what the Fed’s critics would argue could’ve happened.

However, it’s tough to imagine achieving this without lower employment. Perhaps payroll employment would be above 147 million, and the unemployment rate would be below 5.9%. But it’s hard to see the figures being very close to the 155 million and 3.6% levels we enjoy today.

The Trade-Off: Inflation or Unemployment

This type of trade-off is worthy of philosophical inquiry: Is it better to have moderate inflation with 147 million people employed as 8 million struggle for work? Or is it better to have high inflation with 155 million people working and only 3.6% of the workforce unemployed?

The answer to this question ultimately depends on one’s values and priorities. For example, do we prioritize low inflation, even if it means sacrificing employment, or do we prioritize high engagement and accept higher inflation as a trade-off?

Related Facts

• The Fed’s ongoing strategy for bringing down inflation is to raise interest rates, which makes borrowing more expensive, thereby reducing demand in the economy.
• The Fed has a dual mandate of maximum employment and stable prices, which means they’re tasked with keeping inflation low without sacrificing engagement.

Key Takeaway

The hypothetical scenario of the Fed acting more aggressively against inflation raises essential questions about the trade-offs between low inflation and high employment. While it’s impossible to know the outcome, it’s clear that the Fed’s actions have contributed to the strong labor market we see today. So the real question is whether or not we’re willing to sacrifice high employment for the sake of low inflation.

Conclusion

Over the past year, the Fed’s monetary policy has been criticized for being too slow to act against inflation. However, it’s essential to consider the trade-offs between low inflation and high employment. The current strong labor market highlights the benefits of the Fed’s actions but also brings to light the philosophical questions about what we prioritize as a society.