As Growth Decouples From Employment, the Fed Faces a Trilemma
PHILADELPHIA – I must have written at least four essays on the trade-off between unemployment and inflation during my undergraduate days. Back then, the focus was invariably on the Phillips curve – the postulated relationship between inflation and jobs – and its derivatives. The expectations-augmented Phillips curve, for example, recognized that current inflation dynamics are heavily affected by forecasts of future outcomes.
While not all economists fully accepted this notion, there was enough agreement about the basic trade-off to project, at least in the short run, that the lower the unemployment rate falls, the higher the rate of inflation will rise (and vice versa). The imperative to balance the two was formally captured in the “dual mandate” that Congress gave the US Federal Reserve (the world’s most powerful central bank) back in 1977. Thenceforth, the Fed’s task was to achieve both price stability and maximum employment.
Over time, however, the inflation-unemployment relationship has proved less stable and predictable than believed. For example, in the three years that followed this decade’s peak CPI (consumer price index) inflation, which topped 9% in 2022, US price growth slowed sharply, to around 3%, while the unemployment rate remained remarkably stable, at around 4% – a level widely considered to constitute “full employment” in the United States.
This configuration – resilient employment alongside rapid disinflation – came as a major surprise not only to a broad swath of economists but also to Fed Chair Jerome Powell. In August 2022, Powell had soberly warned of “some pain” ahead as the Fed hiked interest rates to counter the inflation it had mistakenly characterized as “transitory.” No less surprised were forecasters like Bloomberg Economics, which famously declared, in October 2022, that the probability of a recession in 2023 had hit 100%, owing to aggressive rate hikes by the Fed.
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