By Howard Schneider

WASHINGTON (Reuters] – Inflation is on the rise and unemployment in America is decreasing. The Federal Reserve has begun to increase its interest rates faster than expected.

It is an actual test for the Fed’s new approach to monetary policies, which it adopted in August 2020. This framework was designed to stop the Fed reacting quickly to inflation concerns and shorten what it promised would be an “inclusive and broad” recovery in employment.

Fed policymakers are expected to show their reactions to realized inflation, which is much greater than anticipated, at the Fed’s meeting next week. They will also demonstrate how their projected interest rate responses to this year’s higher unemployment rates.

THE PRELUDE

The 2007-2009 recession and financial crisis led to a period of unprecedented growth in the U.S. There was also evidence of profound change. While the unemployment rate dropped steadily, it was not consistent with economic theory that inflation has actually increased. Slowly, the Fed raised its interest rates. Some policymakers are unsure if this was necessary.

WHAT IS THE NEW APPROACH?

After a two year review, the Fed stated that it will try to increase job growth by focusing on average inflation rather than the target of 2%. It also committed to keeping interest rates low until inflation rises. With its current policy guidance it put this strategy into practice, promising that rates wouldn’t rise until inflation reached 2%. However, the Fed was well within its target to surpass that level for some time.

This new strategy was implemented in the midst a pandemic. With unemployment high, inflation low, and the expectation that the economy would continue to behave the same way as before, low unemployment and low inflation were possible.

They have instead run in opposite directions as in the past, when high unemployment was associated with rapid price rises.

WHAT HAPPENS TO INFLATION AND JOB JOBS?

The Fed has deemed this the best year for inflation.

It has always been somewhat ambiguous about the labor market. Maximum employment was referred to in the new framework as “broad-based, inclusive, and not directly measurable” language. This meant that the Fed wouldn’t just focus on the national unemployment rate but also at labor force participation or the recovery jobs for different demographic groups.

The Fed’s forward guidance for the future has been criticized because there are fewer jobs today than in previous pandemics, less people looking for work and women are still not participating fully in the labour market. Also, the Black unemployment rate is high.

However, employers are paying more for wages and other expenses, which could lead to future inflation.

The current unemployment rate of 4.2% is lower than the Fed would have raised rates in the past.

So what’s next?

Soon, we will be able to see what all this means. Some were critical of the lack of detail about inflation levels and expectations regarding the future job market. It may be that the Fed finally shows its hand by updating its economic outlook and forecasts.