The Federal Reserve Must Be Careful Not To Jeopardize the Strong Economic Recovery

The economy has recovered very quickly from the turmoil of the pandemic, even in the face of new, unforeseen challenges.¹ Economic and job growth are at historically high levels,² and lower-wage workers have shared more equitably in this recovery than they have in previous ones.³ However, heightened inflation has emerged as a persistent challenge, not just in the United States⁴ but around the globe.⁵ And despite strong wage growth,⁶ many Americans are struggling to make ends meet as the prices of many goods and services continue to rise.⁷

The Biden administration has taken actions to ease supply chain bottlenecks and reduce household costs in the short term, while also working to expand the economy’s productive capacity over the long term. At the same time, the administration has rightly respected the Federal Reserve’s independence to take action to combat inflation, which the Fed has done by raising its key short-term interest rate. While the Federal Reserve’s actions could ultimately slow inflation by lowering demand, there is a real danger that by too aggressively targeting inflation, it could increase the risk of a recession.

Importantly, the current inflation challenge is largely caused by supply constraints and unique pandemic-related circumstances, rather than a wage-price spiral or unanchored inflationary expectations—which, as explained below, has historically been the case. The Federal Reserve’s inflation-fighting playbook is to suppress aggregate demand with no direct impact on supply.

Furthermore, many groups of workers, such as women,⁸ people of color,⁹ disabled workers,¹⁰ and those with less than a college degree,¹¹ are still struggling in the face of higher unemployment rates and persistently low wages and/or pay and wealth gaps. And these same groups would likely be the first to feel the fallout from a slowing economy, never mind a recession.

This issue brief argues that the Federal Reserve must work to maneuver a “soft landing,” ensuring that price stability is gradually restored without jeopardizing the economy’s strength and the labor market’s momentum.

There is a fair amount of global economic uncertainty, creating massive economic headwinds. Russia’s war in Ukraine is ongoing; the COVID-19 pandemic and its associated disruptions, including lockdowns in China, endure; and climate change remains a constant threat, particularly as the western United States faces massive droughts. All of these factors create economic upheaval, especially in global supply chains, which is reflected in unexpected price spikes. Inflation is a global phenomenon: Comparable nations are experiencing similar or higher inflation rates than the United States. For example, across Organization for Economic Cooperation and Development countries, inflation is at 9.2 percent, and within the G-20, inflation stands at 8.5 percent.¹²

Fortunately, the U.S. economy and labor market have maintained their momentum throughout this period of heightened risks, in large part because of the historic investments that Congress made in the economic recovery—for instance, by passing President Joe Biden’s signature American Rescue Plan Act in March 2021.¹³ Without these investments, it is likely that a sluggish recovery would have followed: The United States would have been at risk of a double-dip recession, added far fewer jobs, and seen a much higher unemployment rate.¹⁴

The current strength of the economy is apparent in the numbers. Since January 2021, the United States has added 8.6 million jobs—the highest number of jobs added in any president’s first 16 months—and 96 percent of the jobs that were lost at the start of the pandemic have been regained. Meanwhile, the unemployment rate¹⁵ and layoffs¹⁶ remain at historic lows, while job openings are at near-record highs.¹⁷ This historically strong labor market would likely not have been possible without the American Rescue Plan, which led to the creation of 1 million to more than 4 million additional jobs.¹⁸ And in 2021, Americans reported that they were more financially secure than in previous years.¹⁹ For example, 68 percent of households could come up with $400 to cover an emergency in late 2021—the largest share since 2013, when the Federal Reserve started to collect this information.²⁰

The strong labor market recovery reflects the quick economic rebound after the pandemic. The U.S. economy grew faster last year than it has in nearly 40 years,²¹ and the Congressional Budget Office (CBO) projects that real gross domestic product (GDP) will continue to grow by a healthy 3.1 percent this year.²² In fact, according to the International Monetary Fund, the U.S. economy will grow faster this year than most other advanced economies.²³

While the economy is currently much stronger than forecasters expected, it is not invulnerable to a slowdown or even a recession. In particular, if the Federal Reserve were to raise interest rates too quickly, it would threaten the historic progress that has been made in the U.S. labor market and economy more broadly. For that reason, it is critical that policymakers in Congress and at the Federal Reserve safeguard these historic achievements and maintain the recovery, especially as many vulnerable groups are still lagging behind.

The quick recovery from a historically disruptive global pandemic has introduced new challenges. Persistent, higher-than-average inflation has hurt families’ budgets and received the attention of policymakers, especially at the Federal Reserve. Yet while inflation has persisted at a high level for longer than many expected, there are signs that it is already easing. For instance, April’s personal consumption expenditures price data showed that annual inflation is declining.²⁴

Data on prices also suggest that there is no massive urgency to act too aggressively. Usually, the Federal Reserve worries about both inflation expectations becoming unanchored and a wage-price spiral; in this case, there is no evidence of either. The data so far do not suggest that inflation expectations are changing over the longer term, meaning that people anticipate that inflation will begin to slow down again.²⁵ Moreover, there is no evidence to suggest that wages and prices are driving each other higher.²⁶ While wages and prices have risen at the same time, they have done so independently of one another—and both have already started to slow in the spring of 2022. Recently, in May 2022, Fed Chair Jerome Powell stated, “We don’t see a wage-price spiral.”²⁷

Taken together, this means that the Federal Reserve has some wiggle room for tackling inflation, as the threat of out-of-control inflation is not apparent—although it will need to remain vigilant about these factors changing in the coming months. The data also suggest that the Federal Reserve has more room to pursue its dual goal of price stability and maximum employment.

Put another way, the Federal Reserve does not have to choose between price stability and full employment and can likely avoid pushing the economy into an unnecessary slowdown or even a recession.

While the Federal Reserve has a dual mandate of price stability and maximum employment,³⁵ there are indicators that the labor market has not yet reached maximum employment. Therefore, the United States must maintain its tight labor market and booming economy in order to help those who might be left behind. This is especially important since Congress has not addressed obvious shortcomings in the nation’s social safety net, such as by extending the expanded child tax credit to help parents, investing in care infrastructure in a meaningful way, and addressing the myriad holes in the country’s unemployment insurance system. Families need the strong economy and labor market recovery to continue since the alternative of slower growth—or worse, an economic contraction—would mean that many would fall through the cracks and face financial hardships.

If the Federal Reserve were to singularly focus on slowing inflation and raise its short-term interest rate too aggressively, it could put many households’ finances at risk. Overly tight monetary policy—a rapidly rising short-term interest rate—could also substantially increase the chance of much slower growth or even a recession. In particular, workers of color as well as other vulnerable workers who are already struggling amid higher unemployment rates and fewer economic resources—meaning income and wealth—will be the ones feeling the brunt of an economic slowdown. The old adage of “last hired, first fired” will come to life again, and economic inequity by race,³⁶ ethnicity,³⁷ gender,³⁸ disability,³⁹ and LGBTQI+ status,⁴⁰ among other factors, could widen.

Disparities persist

Fortunately, the American Rescue Plan Act’s massive people-centered investments in the economy made the labor market recovery more equitable than during other recoveries.⁴¹ Indeed, those who typically are left behind during recessions saw similar gains as other groups in 2021. In particular, the Black, Hispanic, and youth unemployment rates experienced record calendar year drops and are now at or below pre-pandemic levels.⁴² Black or African American⁴³ and Hispanic or Latino⁴⁴ men’s unemployment rates are also near historic lows.

However, existing inequities persist as many women,⁴⁵ people of color⁴⁶ and disabled people⁴⁷ continue to face employment gaps and often higher unemployment rates than headline numbers. (see Figure 1) Put differently, as is typically the case with recessions, inequality did not worsen during the pandemic-induced recession.⁴⁸ Despite this fact, widespread inequities persist, notably by race,⁴⁹ ethnicity,⁵⁰ gender,⁵¹ disability,⁵² and LGBTQI+ status.⁵³

Figure 1

Long-term unemployment has fallen sharply

In the United States, long-term unemployment has fallen sharply by historic standards—unlike what happened after the Great Recession,⁵⁴ when the scourge of long-term unemployment became ever more widespread amid a sluggish recovery.⁵⁵ In fact, in the 12 months after the American Rescue Plan Act passed, the number of long-term unemployed people fell by a record 2.8 million—the largest 12-month drop on record.⁵⁶ (see Figure 2) And the average length of unemployment never reached the historic high of more than 40 weeks following the Great Recession and has trended downward since the middle of 2021.⁵⁷

Figure 2

A sharp drop in long-term unemployment is welcome news: “Scarring” from being unemployed for long periods of time can and does have devastating impacts on individuals, families, communities, and the wider economy.⁵⁸ If the Federal Reserve hits the brakes too hard, the labor market could experience a recurrence of rising long-term unemployment rates amid slow growth, as was the case after the Great Recession.⁵⁹

Wage growth has been strong across the income spectrum

In the summer of 2020, businesses quickly raised wages in many sectors as the economy started to rebound.⁶⁰ Wage gains were especially pronounced in lower-wage⁶¹ service sectors,⁶² such as restaurants, hotels, and nursing homes, that had suffered large job losses at the start of the pandemic and where workers had faced massive health challenges during the pandemic. Many of these wage gains persisted throughout 2021 and, for a while, kept pace with rising prices.⁶³ Inflation-adjusted wages in restaurants and hotels were 3.6 percent higher in April 2022 than in April 2021, according to U.S. Bureau of Labor Statistics data.⁶⁴

Other low-wage sectors such as nursing homes and child care also had positive inflation-adjusted wage gains during this period. These gains are remarkable not only because wages outpaced prices at the bottom of the income scale but also because the people who are usually the last ones to get their jobs back and see wage gains in an economic recovery saw at least proportional gains during this one.

Yet an overly aggressive Federal Reserve response could set back workers who, after so many years of falling behind, have just barely started to get ahead.

While inflation poses an economic challenge for people, businesses, and policymakers, all levers of economic policy—monetary policy, macroeconomic policy, and regulatory policy—are working to combat it.

Specifically, the Biden administration has taken steps to lower costs by strengthening supply chains and combating corporate concentration, including by:

• Strengthening the nation’s supply chain through domestic manufacturing and expanding the capacity of ports and waterways, which keeps prices down and shelves stocked
• Releasing 1 million barrels of oil from the Strategic Petroleum Reserve each day to increase supply and keep prices down and enacting the Defense Production Act to spur production of critical minerals for electric vehicles and renewable energy storage
• Taking a whole-of-government approach to crack down on companies’ anti-competitive behavior, which has been driving up prices⁶⁵
• Working to increase competition in the meat- and poultry-processing industry and to create a more resilient supply chain⁶⁶
• Passing the bipartisan Infrastructure Investment and Jobs Act, with investments in roads, bridges, broadband, and other infrastructure measures that would reduce costs for businesses and make it easier for people to start and grow new businesses, while also gradually easing inflationary pressures over time⁶⁷

As a result of the Biden administration’s actions, there is less pressure on the Fed to reduce inflation, as it does not have to steer against other policy tools at the same time. Indeed, monetary policy—or raising the short-term interest rate—is not the only tool policymakers have to address inflation.

The Federal Reserve must work to both manage inflation and maintain growth. But above all, it needs to exercise caution so as not to raise interest rates too aggressively; otherwise, it risks putting millions out of work and reversing the historic progress of the labor market and economy. Moreover, the adverse effects of overaggressive Fed action would fall hardest on those that are least able to afford it, notably low-wage workers and historically marginalized groups.