Federal Reserve meets difficult decision between inflation and employment

A recent article from Reuters illustrates the precarious situation in which the Federal Reserve finds itself regarding the opportunity cost between inflation and U.S unemployment.

The U.S economy has recently seen rising employment rates as the economy rebounded from the COVID-19 pandemic where unemployment hit highs of up to 14.7% in April of 2020 as firms saw a massive loss of demand.

This loss of demand was attributed to COVID-19 restrictions within certain states in the U.S as well as reduced consumer confidence as COVID-19 raises uncertainty for consumers due to the possibility of falling ill.

Because of the inherent health risk associated with COVID-19, the majority of consumers have turned to stay at home to reduce the risk of contracting COVID-19, and this new habit of staying at home has seemingly changed the tastes and fashions of consumers spending and consumption wise.

Consumers began to save more as many were unsure if they would keep their jobs, as well as this, more consumers began to shop online as it maximised their utility due to the fact that online shopping reduces COVID-19 infection risk.

Consequently, as consumers spend less, demand for goods and services, especially those in hospitality, catering and retail, decreases.

As a result of this, the profits of firms within these industries tank, thus leading to firms laying off workers in an effort to cut costs as reducing laboru costs is one of the fastest ways of retaining cash flow.

And in the end, this chain of events leads to cyclical unemployment rising as the negative multiplier effect of firms laying off workers dries up demand for other sectors of the U.S economy.

However, with an ever successful vaccination rollout, consumer confidence is increasing once again as the risk associated with COVID-19 is slowly reducing, because of this, consumers are becoming ever so eager to splash their lockdown savings on goods and services which they have missed out on during the pandemic such as going to pubs and restaurants.

Because of this increasing consumption within the U.S economy, aggregate demand has also increased, consequently, the output of the U.S economy rises as the nation achieves short-run economic growth.

This rise in economic growth means that the U.S economy has seen increased output as the economy moves towards being more productively efficient, in other words, there are less wasted resources.

So, because fewer resources are being wasted, unemployment falls as more workers are required by firms to produce more and to raise output throughout the economy and this unemployment decrease can be illustrated below by the data provided by TRADING ECONOMICS.

At the same time, a rise in aggregate demand means that price levels are rising as newly employed workers, due to a rise in output, spend their newly earned disposable incomes on goods and services, thus generating demand-pull inflation.

Because of this, the U.S CPI inflation rate has drastically risen to 5.0% in May as shown below.

This rise in the CPI inflation rate places it way above the U.S governments target of 2.0% which means that the Federal Reserve, America’s central bank, is tasked with getting it back on target.

To do this the American Federal Reserve will have to implement contractionary monetary policy measures by introducing policies such as the selling of government bonds, which decrease the money supply, as well as increasing the federal funds rate, base interest rate.

These measures will increase the cost of borrowing, the cost of servicing debt and will also increase the benefits of saving, all of which decrease aggregate demand within the economy from consumers and businesses alike.

This decrease in aggregate demand will lower the rate at which price levels rise, thus helping the U.S economy go back to a low and stable inflation rate of 2.0% CPI.

However, this decrease in aggregate demand will also lower output, which may be detrimental to the U.S economy as this means that unemployment may potentially rise again, which is significant as there are still millions unemployed, Reuters reports.

ISI Evercore Vice-Chairman Krishna Guha wrote this week that “for the first time in a while, we are cautious heading into the June Fed meeting this week,” he later added that “it has gone in the direction of a near-term conflict between the Fed’s employment and inflation goals.” Hence this marks a situation that policymakers, as well as our team at The Backseat Economist, will be observing very carefully.


Written by Hubert Kucharski


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