There's no slack in the Fed press corps. Photographer: Andrew Harrer/Bloomberg
There's no slack in the Fed press corps. Photographer: Andrew Harrer/Bloomberg

The Federal Reserve’s decision yesterday to drop its commitment to keep interest rates near zero until the unemployment rate is below 6.5 percent shows that monetary policy has arrived at a new challenge: how to change tack as the U.S. economy reaches full employment.

It’s not clear how much slack, or spare capacity, is left in the economy, as I’ve written in a series of recent posts. But it seems ever more likely that the answer is not a lot. So advocates for easy monetary policies won’t be able to argue much longer that lots of slack in the economy justifies low interest rates.

Instead, they will have to make a case that the disappointing economy still calls for monetary easing -- and they’re starting to do just that. The new idea is for “overshooting”: the idea that encouraging faster growth, even at the risk of higher inflation, will enable the U.S. economy to recover some of the productivity it lost in the recession.

The millions of unemployed haven’t disappeared, they argue. They’re just waiting for a chance to succeed in a better economy. Accept an overshoot, and most of those workers return to the workforce; deny it, and they don’t.

In fact, many of those who dropped out of the labor force during the recession are highly skilled, according to the Massachusetts Institute of Technology’s Ofer Sharone, a labor researcher I profiled in December. About 40 percent of the drop in labor-force participation was driven by adults age 25 to 54 who chose to stop searching for work. It seems likely that a strong economy could lure them back to the labor market.

Federal Reserve Bank of St. Louis
Federal Reserve Bank of St. Louis

Fed economists David Reifschneider, William Wascher and David Wilcox make that case in a recent paper. It’s an argument cast in technical language -- the “endogeneity of supply with respect to demand” -- but what means is simple: If the Fed engineers a stronger economy, that boost will be enduring, not temporary, if it brings back the labor force and lures more investment. Hitting the brakes now would only ensure that America’s potential continues to shrink from disuse.

When we see sharp wage increases and above-target inflation, then -- not now -- would be the time to step on the brakes by raising interest rates. That’s the only way to know the U.S. has reached the limits of its recovery. What’s the wrong indicator to watch? The unemployment rate, which would call for tightening too soon.

The Fed isn’t likely to embrace an explicit policy of overshooting, which would strike its critics as a willingness to tolerate above-target inflation. But advocates are right in one respect: The costs of giving up too early are surely greater than the risk that the recovery boils over a bit.

Current monetary policy already reflects that -- just not to the extent that doves might like. Markets expect interest rates to stay near zero for a year and a half more. By then, the unemployment rate will probably be just below 6 percent -- which means the Fed will have waited far longer than it usually does before making its exit. So long, in fact, that the U.S. will be at the Fed’s own assessment of “full employment.” That’s a quiet admission that some overshooting is all right.

(Evan Soltas is a contributor to Bloomberg View. Follow him on Twitter at @esoltas.)

To contact the writer of this article: Evan Soltas at esoltas@gmail.com.

To contact the editor responsible for this article: Christopher Flavelle at cflavelle@bloomberg.net.