Thursday, October 5, 2017

U.S. Monetary Policy: What's Up?

To frame the issues, let's look at some objective measures of the Fed's performance. Just to be fair, we'll evaluate performance in terms of the objectives laid out in the FOMC's January 2017 goals statement.

1. "...inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate." Note that the price index the Fed has chosen as most appropriate is the raw, headline pce deflator, not the pce deflator stripping out food and energy, the cpi, the core cpi, or any other measure. So we should hold them to that choice. Here's year-over-year inflation rates, since the last recession:
Obviously the Fed hasn't been hitting 2% inflation spot on, but what's actually feasible, or even desirable? The Bank of Canada, to take an example that's close at hand for me, actually sets a target band of 1-3% for inflation, so by that criterion the Fed has done pretty well - within the 1-3% band for most of the last seven years, except during 2015 after the fall in energy prices, which perhaps is understandable. The current inflation rate is 1.4%, which is tolerably close to the Fed's ideal. But the the Fed also has a "symmetric inflation goal." Missing the target sometimes is OK, but the FOMC would like to miss on the high side about as much as it misses on the low side - roughly, average inflation should be close to 2%. Over the last year, inflation was above 2% for two months, and below for 10 months, with an average of 1.6%. Not quite symmetric, but not so bad.

2. "... it would not be appropriate to specify a fixed goal for employment...Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published...For example, in the most recent projections, the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.8 percent." For good reasons, the FOMC doesn't want to be specific about numerical goals related to the second part of its mandate - sometimes called "maximum employment," whatever that is. There's a hint though, about what the FOMC members might care about, which is the "long run normal" or natural rate of unemployment. This is rather ill-defined and hard to measure. To my mind, the economics profession would be better off if we refrained from mention of "natural" anything. One danger associated with the natural rate, as for any other ill-defined and hard-to-measure variable, is that a policymaker can start making stuff up, so as to manipulate the policy discussion. In the FOMC's most recent projections, the range of estimates for a long-run unemployment rate fall in a range of 4.4%-5.0%, with a median of 4.6%, so notions of what is normal have fallen since January 2017, when the FOMC put together its long-run plans revision. Here's what the actual unemployment rate looks like:
The current unemployment rate, at 4.4%, is as low as any FOMC participant thinks is normal over the long run, conditional on things going really well, apparently. So, by that measure the Fed is doing great.

Just to check, we can look at another measure, which is a measure of labor market tightness (or it's inverse, as conventionally measured in the labor literature). This is the ratio of the number of unemployed to total job openings:
Shortly after the last recession ended, this measure peaked at about 6.6 unemployed people per job opening, and it's now down to close to 1 unemployed person per job opening. Indeed, that's close to the lowest reading since the BLS started collecting this particular job vacancy data. So, by conventional measures the job market is very tight, which should be viewed as extremely good performance on the Fed's part.

What about growth in real GDP?
If we think that part of the Fed's job is to smooth growth in real GDP, then that chart looks pretty good. I've put in a 2% growth path, and the deviations from that growth path are small. Of course, people might complain that 2% growth is lower than the 3% (roughly) post-WWII average, but that shouldn't be the Fed's concern. Received wisdom in the economics profession is that monetary policy can't do much for long-run growth, other than keeping inflation low and predictable.

So, what's to fix here? Inflation is tolerably close to 2%, the unemployment rate is very low, the labor market is extremely tight, and real GDP is growing smoothly. The only improvement to be made is some fine tuning so that inflation fluctuates symmetrically around the 2% target. How should that be done? I'll assume, consistent with my last post, that QE doesn't matter. So the only issue is what should be done to the fed funds target range (or, more accurately, the interest rate on reserves and the interest rate on overnight reverse repurchase agreements), so that the average inflation rate is 2%? Well, you don't have to be a neo-Fisherite to understand that, if inflation is persistently lower than what you want, on average, then the nominal interest rate needs to be, on average, higher in the future. What's needed here is some tweaking of the Fed's policy interest rate target. How much? As mentioned above, the average inflation rate over the last year is 1.6%, so one or two more interest rate hikes will do the trick. Twenty five to fifty basis points' increase in overnight interest rates is small potatoes for real economic activity - note that the labor market continued to improve in the face of the last four interest rate increases.

So, that's what I'd do. What does the FOMC have on its mind? In the last FOMC projections, the median long-run prediction of Committee members for the fed funds rate is 2.8%, with a range of 2.3%-3.5%. That's come down considerably, with recognition by the committee that the low real rates of return on government debt we are observing are likely to persist. A persistently low real rate of return on short-term safe assets implies of course that the nominal short term interest rate consistent with 2% inflation is low. I'm saying that what Janet Yellen would call the "neutral interest rate" (the interest rate target at which the Fed achieves its goals in the long run) is more like 1.5%, and not 2.3%-3.5%.

To get more information on what the FOMC is likely to do over the near future, we'll look at Janet Yellen's last speech on "Inflation, Uncertainty, and Monetary Policy." First, Yellen tells us how inflation has been low, and then says why she thinks low inflation is bad:
Sustained low inflation such as this is undesirable because, among other things, it generally leads to low settings of the federal funds rate in normal times, thereby providing less scope to ease monetary policy to fight recessions. In addition, a persistent undershoot of our stated 2 percent goal could undermine the FOMC's credibility, causing inflation expectations to drift and actual inflation and economic activity to become more volatile.
The second sentence is important. The Fed committed to a 2% inflation target because the assurance of predictable inflation minimizes uncertainty, and makes credit markets, and (by some accounts) the markets for goods and services work more efficiently. If the Fed consistently undershoots its inflation target, people will either think the Fed is incompetent, or that it is willfully abandoning its promises, neither of which is good - for the institution or the economy. But in this instance, the Fed isn't missing by much, so what's the big worry? As I mentioned above, this requires some fine-tuning, but don't get bent out of shape about it.

The first sentence in the quote was really interesting. She's got the causality backward. Pretty much all of us now accept that it's the central bank that controls inflation. That is, central bank actions or, more accurately, the central bank's policy rule, causes inflation to be what it is, combined of course with other factors outside the Fed's control - including the factors determining the long-run real rate of interest on government debt. So, low inflation does not lead to "low settings of the federal funds rate." It's the low settings for the fed funds rate that lead to the low inflation. In a world in which the central bank targets the nominal interest rate to control inflation, that's how it works, and central bankers would be wise to absorb that idea. Stop the neo-Fisherian denial, and get with the program!

The speech uses a two-equation model (written down in the appendix) to frame the issues. It's a Phillips curve model. Arrgghh. Even Larry Summers recognizes that Phillips curves are unreliable. As he says:
The Phillips curve is at most barely present in data for the past 25 years.
For example, in the recent post-recession period, here's what we get when we plot inflation against the measure of labor market tightness I used above (ratio of unemployed to job seekers):
The line connects the observations in temporal sequence from right to left. Over this period of time, I think the Fed would claim that inflation expectations are more or less "anchored." So, what we should see in the chart, if the Phillips curve is to be at all useful, is a set of observations tracing out a downward-sloping relationship. But, more often than not, inflation and my "slackness" measure are moving in the same direction. There's nothing new about macroeconomists raising issues with the Phillips curve as a cornerstone for policy. It's been in disrepute for much of the last 45 years or so, both on theoretical and empirical grounds. Unfortunately, the Phillips curve was dragged out of the gutter, dressed up, and rehabilitated by New Keynesians, which is another story altogether.

But, like a lot of people, Janet Yellen is a true believer, and her staff will aid her in that belief by going on a fishing expedition and finding a Phillips curve, and a sample period, for which all the signs in the regressions (if not the magnitudes) come out "right." Here, "right" is whatever conforms to the beliefs of the boss. Sure enough, in the appendix to Yellen's speech, there is a two-equation Phillips curve model. Core inflation is determined by past core inflation, inflation expectations, resource slack, and the relative price of imported goods, and core inflation, energy price inflation, and food inflation determine headline inflation. Yellen's worries about future inflation outcomes are essentially those of the true believer. Do we have the right slackness measure, or the right inflation expectations measure, and how much should we worry if expected inflation falls?

Though Yellen lays out an explicit model of inflation, she doesn't exactly tell us how policy is supposed to work within that framework. Even true believers will sometimes tell you that "the Phillips curve is now very flat," meaning that they think a tighter labor market will put little or no upward pressure on inflation. If we want to stick with the Phillips curve framework, what's left then? The Fed has to focus on anticipated inflation. But how do they move that around? Modern macroeconomics tells us that our views about future outcomes are shaped by what we know about policy rules, in a manner consistent with what we know about how the world works. I got no sense from Yellen's talk of how the Fed thinks its policy rule affects inflation expectations.

But here's the essence of the FOMC's current policy view:
...without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession.
So, in spite of the fact that the Phillips curve doesn't fit the data, the most recent manifestation being the failure of the very tight labor market to make inflation go up, policy going forward will be driven by the fear that the Phillips curve will somehow wake up and re-assert itself. Summers thinks that's wrong, and rightly so.

But, I think Yellen and her colleagues are actually following the right policy. Modest increases in the Fed's interest rate target in this context is the correct prescription. But doing the right thing for the wrong reason won't help you in the long run. We're fortunate, though, that not much is likely to go wrong here. If inflation stays low, and the FOMC loses its appetite for interest rate increases, so what? Low inflation is fine, and it's close enough to 2% as not to be embarrassing. No big deal.

Monetary policy is the least of our now-staggering problems. Unfortunately, the wingnut in the White House is busy creating more difficulty for us, and making the problems we have worse. Fortunately, he has as yet not screwed up the Fed, and the slate of would-be Fed Chairs doesn't include anyone outlandish. More on that later.

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