If you think the FOMC is confused, this speech by Charles Evans, Chicago Fed President,
might tell you why.
First, Evans wants to take the Fed's dual mandate very seriously - never a good idea. The so-called Humphrey-Hawkins Act of 1978 mandates, in somewhat vague language, that the Fed foster price stability and also pursue policies that promote growth and employment. There is a problem, though. It is essentially universally-accepted among economists that a central bank can control the rate of inflation under most circumstances, though there may be particular circumstances, such as exist currently, under which that is not entirely true. It is also widely-accepted that money is neutral in the long run, and there is much disagreement about the nature and quantitative significance of short-run nonneutralities of money. Thus, any group of economists and non-economists finding themselves sitting in an FOMC meeting will have a hard time interpreting what the dual mandate dictates they should do, and they certainly will not agree on what the Humphrey-Hawkins prescription is.
The Fed has found creative ways of getting around this problem however. First, in speeches by Fed officials and in FOMC statements, lip service is paid to the dual mandate, but the Fed could actually be more-or-less ignoring the real side of the economy. Second, the Fed often uses Phillips curve language, in spite of the fact that the Phillips curve is a problematic object with a sordid history, and output gaps and unemployment rates are of demonstrably little use in forecasting inflation. Why does the Fed do this? Because this is a convenient way to get agreement among FOMC members - if real GDP growth is expected to be high (low) then the Phillips curve tells us that inflation will be high (low), and all the FOMC members vote to tighten (ease), whether they are Keynesians or not. Third, it can be convenient for Fed officials to speak in public about how a low and stable inflation rate actually fosters economic growth. By this logic, in fulfilling one part of the mandate, the Fed can fulfill both, and kill two birds with one stone. The logic is also correct, though we could argue about the quantitative effect of inflation on economic growth.
None of this namby-pamby vague central-bank-speak for Evans, though. He wants to interpret the dual mandate in terms of hard numbers. According to him, the "natural rate" of unemployment is 6%, and price stability means an inflation rate of 2%, so the bliss point for the US economy is a 6% rate of unemployment and a 2% rate of inflation, and the Fed's performance should be measured in terms of a quadratic loss function. Why? Mike Woodford told him it was OK.
What should the Fed do under the current circumstances? Evans anticipates that the inflation rate will fall below 2% and the unemployment rate is of course well above 6%, so the choice is clear for him: there should be more monetary accommodation. Implicit in this argument of course is the Phillips curve - more monetary accommodation implies more inflation and less unemployment. But how much accommodation? For Evans, this is just a matter of what coefficients go into the quadratic loss function. He clearly puts a low weight on the losses from high inflation and a high weight on the losses from high unemployment, so he is willing to bear a much higher inflation rate so as to bring unemployment down.
There are three problems here.
1. Evans is forgetting the lessons of the 1970s.
What Evans is proposing is a change in the policy rule - a change in how the state of the economy maps into actions by the Fed. What economists understand today that they did not in 1975, is that commitment by the Fed to a policy rule is critical for its success in fulfilling its mandate. Once the public understands that the Fed intends to exploit a short-run Phillips curve relationship (and the problem is worse if the short-run inflation/unemployment tradeoff in fact does not exist), then all bets are off. High inflation can become well-entrenched and we have to go through an episode like the policy-induced "Volcker recession," followed by a long period where the Fed re-establishes its credibility. This is exactly the logic, I think, behind Kocherlakota's dissent at the last FOMC meeting.
In the 1970s, the Fed was dominated by many well-intentioned people much like Charles Evans, and they got us into trouble.
2. What is the economic inefficiency that Evans thinks he is trying to correct?
By efficient, I think we mean a state of affairs that is optimal from the point of view of a policymaker - there is nothing that a policymaker can do given that state of affairs to increase aggregate economic welfare. Evans seems convinced that the state we are in is not efficient. In this quote, he comments on "the story" that interprets our bad state of affairs as intractable, from a policymaker's point of view:
I suppose it is natural to believe that some elements of the story are true. But for me, the evidence for this is minimal, and the implications for productive capacity are exceedingly pessimistic. And even if it is true, the market mechanism should cause wages and prices to adjust in order to reemploy unused resources. For example, there should be some lower real wage that would make it profitable for firms to fund the necessary on-the-job training for workers who need some modest acquisition of skills. According to this pessimistic hypothesis, something is preventing the market’s pricing mechanism from achieving such results within a satisfactory time frame.
This seems confused. What he seems to be saying is that theories that attribute a rise in the unemployment rate to frictions associated with sectoral reallocation must rely on price or wage distortions. However, the sectoral reallocation frictions that typically come into play in these discussions involve the time and effort associated with acquiring sector-specific human capital, information frictions, and the costs of moving labor across geographical regions. One would think that wage and price distortions might be key to Evans's argument - he's clearly a hardcore Keynesian, and one would not think he would be appealing to wage and price flexibility to shoot down the alternative case.
So what is our key macroeconomic problem, from Evans's point of view?
...I think the evidence favors the belief that aggregate demand is simply much too low today.
Arrrgghhh. If all economists could take a pledge never to use the words "aggregate demand" again, the world would be a better place. What Evans is saying is that he does not know what is going on. Aggregate demand is Keynesian language. When the language is used, what it means is that there is an inefficiency that the monetary and/or fiscal authority might be able to correct. In Keynesian theory, the inefficiency can come from two sources: (i) sticky wages and prices or (ii) multiple equilibria. The specifics of the inefficiency actually matters for what the optimal policy response is. Which prices are sticky and which are not? Are the prices sticky, are the wages sticky, or both? If the problem is not sticky wages and prices but the fact that we are just in a bad equilibrium, the solution to getting to the good equilibrium might be quite different than solving the price/wage distortion problem.
Further, Evans tells us about Reinhart and Rogoff, the debt overhang, and how this prolongs our economic recovery. How does he know that the "unused resources" he is seeing are not unused because of the financial problems created by the recent crisis? Debt overhang in the economy may create conditions under which those resources will go unused, no matter what the Fed does. Did debt overhang actually go into Evans's 6% "natural rate of unemployment" calculation?
3. How can the Fed actually be more accommodative under current conditions? As I have discussed before,
the Fed has only one policy instrument given the large quantity of excess reserves in the financial system: the interest rate on reserves (IROR). Quantitative easing, or changes in the maturity structure of the assets on the Fed's balance sheet will accomplish nothing. Thus, to be more accommodative through current actions is impossible, unless the IROR goes to 0%. Bernanke told us a year ago that this was not on the table, but maybe he has changed his mind. In any case, setting the IROR at 0% will not change anything much. However, the Fed can change its statements about the future path of the IROR, and that can matter.
Evans suggest three types of "forward guidance," that the Fed could contemplate. The first is a policy rule explicitly contingent on the unemployment rate. The second is contingent price-level targeting, and the third is nominal GDP targeting. The first policy is quite ill-advised, partly for reasons discussed above, but in particular because the "natural rate of unemployment," whatever it is (there are many definitions) is a moving object, and it moves in unpredictable ways. The other two proposals actually do not imply anything especially new about how we formulate policy, as you ultimately have to reformulate those things in terms of a rule for the policy interest rate.
Some of what Evans contemplates would open up the possibility of a future with high and sustained inflation. Evans should think carefully about which he prefers - some heat from Krugmaniacs and the unemployed about unused resources, or a lot of heat from everyone about the high rate of inflation.