Bringing the United States Economy Back into Balance

IMF News, February 16, 2023

Source details

The US Federal Reserve has been raising interest rates to restore price stability and to bring balance to the labor market.
The demand for new hires is exceeding the supply of available workers in the US, as the unemployment rate has fallen to its lowest level in over 50 years, and this has contributed to higher inflation.
Growth of prices in the personal consumption expenditure index is now around 5½ percent, well above the 2 percent target.

Since mid-2021, as the US economy rapidly recovered, the demand for workers has far outstripped the supply.
Workers have become more likely to quit jobs and look for new ones; early retirements have also reduced the supply of available workers.
These factors increased workers’ bargaining power, contributing to higher wages and prices as firms raised prices to cover rising wage costs.
Labor-intensive industries, such as hotels and restaurants, have been especially affected.

Model-based analysis by Fund staff using the Fed’s FRBUS model indicates the Fed could achieve price stability and maximum employment by:
- Raising interest rates to a peak of 4-5 percent, and
- Sustaining that peak for around 1-1½ years, taking into account workers’ strong bargaining position and the high number of vacancies per unemployed worker.
The mechanism: higher interest rates would weaken the demand for workers and increase unemployment modestly, reducing pressure for large wage and price increases—particularly in the services sector—and helping to lower inflation.

Most Federal Open Market Committee members project further interest rate hikes, so that the federal funds rate would remain around 5–5½ percent at the end of 2023.
There are encouraging signs that the Fed’s policy moves are having the intended impact: inflation slowed in the last quarter of 2022 (relative to the summer), driven by declining goods prices.
Inflation in services prices remains elevated and will likely only fall once wage growth slows.

Staying the course and keeping interest rates elevated this year will tame inflation.
Although higher rates will temporarily increase unemployment, they are expected to pave the way for stable inflation and sustainable economic growth, which will ultimately help create more jobs in the future.
Bringing inflation down to the Fed’s 2 percent target is crucial for stable job growth and sustainable increases in incomes over the medium to long-run, and it will offset the cost of temporarily higher unemployment.

Bringing the United States Economy Back into Balance — By Andrew Hodge, IMF Western Hemisphere Department, February 16, 2023.