How DEI Made Inflation Worse

T he Federal Reserve is tasked with conducting monetary policy in accordance with a dual mandate of maximum employment and stable prices. The Fed has traditionally used these goals as guidelines to help improve economic stability.

Under pressure to implement diversity, equity, and inclusion (DEI) initiatives, however, the Fed revised its monetary-policy objectives to make its employment target more “inclusive.” Pursuit of this goal was one reason that the Fed maintained an overly expansionary policy, with consequences of which we have only just been reminded.

For years, a number of politicians have been pressuring the Fed to implement DEI policies regarding race and income inequality. President Joe Biden, for example, has encouraged the Fed to “aggressively target persistent racial gaps in jobs, wages, wealth.” The House of Representatives recently passed a bill that would go even further, tasking the Fed with “the elimination of racial and ethnic disparities in employment, income, wealth, and access to affordable credit.”

But monetary policy is not the way to target inequality, which is a structural issue better dealt with at the broader political level rather than by tinkering with interest rates. Monetary policy is a blunt tool that affects the entire economy. It cannot focus on specific subsets of the labor force. Fed chairman Jerome Powell and his predecessors Janet Yellen and Ben Bernanke have all said that monetary policy is not capable of resolving disparate labor-market outcomes. The best it can do is promote economic growth that will benefit all workers and consumers.

Despite widespread agreement that monetary policy cannot fix inequality, Fed officials decided to try it anyway. In August 2020, the Federal Open Market Committee (FOMC) redefined its monetary-policy objectives to be a “broad-based and inclusive” measure of employment. Powell argued this would create particular benefits to “low- and moderate-income communities.”

How could the Fed promote inclusive employment if monetary policy is incapable of targeting inequality? The idea is that racial wage gaps shrink as the economy approaches its maximum sustainable potential. As the labor market tightens, businesses become willing to pay higher wages to entice workers who might otherwise sit on the sidelines. Such increases in labor demand tend to disproportionately benefit minority and low-skilled workers.

While minority unemployment rates have always been higher than the average for all races, the gap is smaller when the unemployment rate falls to very low levels, historically around 4 percent or below. This was the case in 2019, for example. As Powell described, “Black and Hispanic unemployment rates reached record lows, and the differentials between these rates and the white unemployment rate narrowed to their lowest levels on record.” By pushing the economy toward its maximum sustainable potential, Fed policy would drive minority unemployment rates down closer to the average rate.

This new approach marked a philosophical change in monetary policy. Prior to 2019, the Fed pursued (or attempted to pursue) a neutral monetary policy that supported economic growth and resulted in the lowest minority unemployment rates on record. In 2020, they switched to an activist policy to push the economy back to maximum employment as quickly as possible. Essentially, they tried to squeeze a decade’s worth of growth into a two-year recovery.

In February 2021, Powell promised to continue the Fed’s expansionary policy of open-market purchases and near-zero interest rates until a “broad and inclusive” maximum employment was reached. He also promised, however, that “if excessive inflationary pressures were to build . . . we would not hesitate to act.” Inflationary pressures did build, but the FOMC did not act to contain them. Instead, it maintained low interest rates and continued its open-market purchases in pursuit of its new, inclusive, maximum-employment goal.

The FOMC stuck to this overly expansionary policy even after it became clear that inflation was higher and more persistent than the FOMC had originally predicted. Through 2021, Powell repeatedly stated that the FOMC would keep interest rates low until the economy achieved maximum employment and until inflation was expected to exceed the FOMC’s long-run target of 2 percent “for some time.” Despite repeated upward revisions in its inflation projections, the FOMC continued its open-market purchases and kept its interest-rate targets in the range of 0 to 0.25 percent for the entire year.

This extended period of monetary stimulus was enabled by another policy revision: the adoption of average inflation targeting. The FOMC had previously targeted a rate of 2 percent inflation per year. That goal was adjusted in August 2020 to target an average of 2 percent over time, but the implementation of this “average” was asymmetric. If inflation was below target, the Fed would push future inflation above the target rate. If inflation was above target, however, it would allow it to remain high. Indeed, the FOMC’s median projection is that its preferred measure of inflation will remain above the 2 percent target until 2025.

Powell now acknowledges that both inflation and employment have gone beyond what the Fed considers ideal. “We have a labor market that’s sort of unsustainably hot and we’re very far from our inflation target,” he said in June. Business investment contracted in the second quarter, and consumer sentiment has collapsed. In a recent survey, 72 percent of private forecasters predicted a recession within the next year, which would cause minority unemployment to rise. In other words, the Fed looks likely to harm the people it intended to help.

By deviating from its traditional mandates, the FOMC helped create inflation that has driven up the costs of living for average Americans by far more than they have seen for decades. The FOMC’s aggressive pursuit of broad and inclusive employment contributed to a dangerous overheating of the economy, which risks a recession that would further aggravate racial employment gaps.

Monetary policy is a poor tool for addressing inequality. The Fed should confine itself to promoting stable prices and economic growth. If needed, Congress should limit the Fed to a single, more tightly defined mandate to maintain stable prices and economic growth for the sake of all Americans.