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commentary

Why the Fed Faces a Dilemma

By Joseph Minarik

This article originally appeared in The Hill on February 04, 2019.

The employment situation report today is a pleasant but puzzling surprise that poses an important dilemma for the Federal Reserve. The economy created 304,000 new jobs last month, which is far more than the 170,000 consensus of forecasters. Considering that the federal government was in a shutdown for over a month, with 400,000 employees idle at home and another 400,000 working without pay, this upward move was indeed welcome. Other indicators in the latest jobs report were positive as well.

The number of hours worked throughout the economy increased, which is another sign of growing production. Hourly and weekly worker pay also increased. Rising wages are obviously good for current workers, but they also send a signal to those adults on the sidelines of the labor market that opportunity is growing. In that vein, although the number of persons unemployed went up, which is not a big surprise given the furloughed government employees, the percentage of the adult population that was either working or seeking to work ticked up by one tenth of a percent.

That is important because it gives the economy the new workers it needs to fill the places of the aging baby boomers who are exiting the labor market in droves. Across the economy, employment went up almost everywhere, including in the traditional goods producing sectors that provide jobs for many of the workers who lost their places during the aftermath of the financial crisis. That again is a good sign for the labor market overall as it is squeezed by the retirement of baby boomers.

This jobs report is great news, but it is also puzzling. Over the last few months, many economists have questioned the durability of the current expansion and have urged the Federal Reserve to put its interest rate hikes on hold. This pitted these “inflation doves” against other economists who are more optimistic. Among this latter group are some who fear that our interest rates have been too low for far too long, creating market bubbles, distorting the economy, and planting seeds for a potential financial crisis. The central bank reflected those concerns in its recent rate increases.

Just a few days ago, the Federal Reserve reacted to those dovish fears of an economic softening because of the trade wars, the Brexit dispute, and the government shutdown by announcing steady rates with soothing language. But today, despite those worries, the labor market has roared back in this most recent jobs report. So what should the Federal Reserve do? Unfortunately, it remains caught between a rock and a hard place.

For decades, elected policymakers for the most part have respected the independence of the Federal Reserve. As a result, it has gained credibility with the financial markets as an inflation fighter. That solid credibility is an extraordinarily valuable asset. If the markets trust the central bank to hold inflation in check, that gives business the confidence to keep their prices steady. But in recent months, Washington has taken to publicly criticizing decisions by the Federal Reserve. This threatens its credibility and raises a chance that the central bank bends to the will of elected policymakers.

When the Federal Reserve perceived that the strong economy faces new downside risks and signaled a pause in raising interest rates at its last meeting, there was immediate financial market reaction that the central bank caved to political pressure. It does not matter whether the Federal Reserve is in fact simply making a neutral economic policy judgment based on the data. If its credibility is questioned, it may have significant costs in the future. If so, rebuilding its credibility could lead to greater monetary restraint and reduced economic prosperity. The jobs report has thrown the central bank yet another curveball. More jobs means great news, but it makes the mission of the Federal Reserve a little bit harder.