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Will the Fed ruin presidential candidates’ job plans?

If the Fed is committed to stopping job creation, there’s little a president can do

July 21, 2015 2:00AM ET

As we complete the fields for the Republican and Democratic presidential nominations, most of the leading contenders are putting forward plans to create jobs. On the Democratic side, Hillary Clinton and her leading rival, Bernie Sanders, are pushing plans for increased infrastructure investment. This would generate jobs in the short term directly by increasing demand. In the longer term, improved infrastructure should make the economy more productive, which would increase wages and make more people want to work.

Both candidates are proposing plans to make college more affordable and to improve training, which would make workers more productive. This should also help increase employment in future years.

On the Republican side, Jeb Bush and Marco Rubio want to cut taxes to give people more incentive to work. Both have talked about raising the Social Security retirement age, which would give people an incentive to work later in life. Other candidates have talked about reducing disability and unemployment benefits, which would give people more incentive to look for work, since they would be unable to support themselves otherwise.

Whatever the merits of these various proposals, the argument that they would create more jobs depends on the assumption that the Federal Reserve Board will allow more jobs to be created. If that sounds strange, then you haven’t been paying attention to the Federal Reserve Board.

The Fed has an enormous impact on the economy, primarily through its control of interest rates. During the recession, the Fed was trying to boost growth and job creation by pushing down interest rates as low as possible. It pushed the federal funds rate, the short-term interest rate that is directly under its control, to zero and has held it there since early 2009.

As the economy continued to languish, the Fed tried to provide a further boost with its policy of quantitative easing. This meant buying up trillions of dollars in government bonds and mortgage-backed securities in order to put more direct downward pressure on mortgage rates, car loans and other long-term interest rates. 

With the economy recovering, the Fed has backed away from its quantitative easing policy, ending bond purchases last year. It is now preparing to raise the short-term interest rate for the first time since before the recession. The explicit goal is to slow the economy and the rate of job creation out of a fear that the economy could overheat, meaning that too many people have jobs.

If the presidential candidates hope that their plans will create jobs, they better start bringing the Fed into the picture.

The concern in this scenario is that wages would start rising rapidly, which would lead to higher prices. That in turn could spark a round of wage increases and, if allowed to continue unchecked, give us the same sort of wage-price inflationary spiral we saw in the 1970s.

The Fed may well be completely wrong in raising these concerns. Some economists, including me, think they are pretty far-fetched, given the continuing weakness of the labor market. The important point is that if it acts to prevent jobs from being created, it will be all but impossible to generate more jobs. To be specific, if the Fed sees some level of the unemployment rate as being a floor, below which it does not want the economy to go, then it can raise interest rates enough to ensure that the unemployment rate does not fall below this floor. Higher interest rates curtail home and car buying and discourage borrowing for new investment. This slows growth and limits job creation.

Many economists, including some at the Fed, think the current unemployment rate of 5.3 percent is the floor or very close to it. Assuming the Fed acts on this view, the best job creation plans of the next president will go nowhere, even if they may in principle be sound. While the president’s plan might generate jobs, the Fed would offset any employment growth with higher interest rates.

A good job creation plan could increase the economy’s productivity, which could in principle push down the true floor to the unemployment rate, but that wouldn’t matter unless the Fed recognized that the unemployment rate could get lower without generating inflation. Many members of the Fed’s open market committee (FOMC), which sets interest rates, did not recognize that unemployment could get below 6.0 percent in the 1990s. They argued for higher interest rates to ensure the unemployment rate didn’t get much below what was then widely believed to be a tipping point.

Fortunately, Alan Greenspan, who was chairman of the Fed at the time, did not share this view. He allowed the unemployment rate to fall well below that level, eventually bottoming out at a year-round average of 4.0 percent in 2000. This allowed millions of workers to get jobs who otherwise would have been unemployed. It allowed tens of millions to see wage gains, as a tight labor market gave them bargaining power for the first time in decades.

Today some FOMC members seem not to have noticed that the employment rate of prime age workers (ages 25 to 54) is still almost 3 percentage points below its prerecession level. That corresponds to 3.8 million fewer jobs. This arguably tells us much more about the labor market than the unemployment rate.

If the presidential candidates hope that their plans will create jobs, they better start bringing the Fed into the picture. The president can influence the Fed. Seven of the 12 voting members of the FOMC are presidential appointees. In addition, the president can influence the political environment in which the Fed makes its decisions on interest rates. The candidates may want to start preparing that environment right now.

Dean Baker is co-director of the Center for Economic and Policy Research and author, most recently, of The End of Loser Liberalism: Making Markets Progressive.

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera America's editorial policy.

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