Thursday, October 25, 2012

FOMC Behavior and the Dual Mandate

In the most recent FOMC statement, we are told the following:
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.
The argument is that we need more accommodative policy because: (i) the FOMC expects that, without such policy, there would be insufficient improvement in the state of the labor market and (ii) inflation is expected to continue below the FOMC's target of 2%. Thus, the FOMC anticipates that it will be missing on both sides of its dual mandate in the immediate future unless it does something about it.

Does the FOMC have it right? I have no idea whether the Fed is confident in its forecasts, whether we would think those forecasts are any good if we knew how they were done, etc., so all I can do is look at actual data. With respect to the "price stability" part of the dual mandate, the Fed has decided that the rate of increase in the PCE deflator is the appropriate measure of inflation. The first chart shows the twelve-month percentage increase in the PCE deflator.
As you can see, by this measure inflation is well below the 2% target - it's about 1.5% currently. But it was also well above the target for much of 2011 and early 2012. At that time, for example in the June 2011 policy statement, the FOMC was inclined to discount what it was seeing:
Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate.
When the FOMC highlights the volatile nature of inflation on the upside and fails to mention it on the downside, one can't help but be suspicious. Further, suppose that we look at the price data in another way, as in the next chart.
In this chart, I show the pce deflator, and a 2% trend, beginning in January 2007. If we were judging the Fed's performance according to a price level target, as in the chart, we would think it was doing phenomenally well. Since early 2009, the actual PCE deflator has not strayed far from its target path, and is currently right on target, particularly with the large increase in the last month.

What about the other part of the Fed's mandate? We can argue about what an economically efficient level of aggregate economic activity is currently in the United States and what influence the Fed can have over it. But what if we take a standard central-banker-New-or-Old-Keynesian approach - something like what I describe in this post? The Congressional Budget Office (CBO) thinks that the current "short-term natural rate of unemployment" is 6%. I have no idea what they think that means, or if it makes any sense at all, but we'll use that number. The actual rate of unemployment is 7.8%, so by the CBO's criterion, the Fed is missing on this side of the mandate.

New Keynesians like to think about monetary policy in terms of a Taylor rule, which specifies a target for the federal funds rate as a function of the "output gap" and the deviation of the actual inflation rate from its target value. According to standard Taylor rules, the fed funds target should go down when the output gap rises and up when the inflation rate rises. You can even fit Taylor rules to the data. I fit one to quarterly data for 1987-2007, and obtained the following:

R = 2.02 - 1.48(U-U*) + 1.17P,

where R is the fed funds rate, U is the unemployment rate, U* is the CBO natural rate of unemployment (so U-U* is my measure of the output gap) and P is the year-over-year percentage increase in the PCE deflator. You can see how it fits the historical data in the next chart.
So that's how the Fed behaved in the past. If it were behaving in the same way today, what would it be doing? Given that U = 7.8, U* = 6.0, and P = 1.5, my Taylor rule predicts R = 1.1%.

Thus, the FOMC may see itself as missing on both sides of its mandate, but if it had been missing in the same way in 1997, the fed funds rate target would be at 1.1%, and the Fed would certainly not have been considering large-scale asset purchase programs, let alone making promises to keep the fed funds rate at 0-0.25% for almost three years into the future.

So, the Fed's behavior seems to have changed. Maybe change is good. Who is to say that behavior from 1987-2007 was optimal? One argument for an extended period of low nominal interest rates comes from Eggertsson and Woodford, and I raise some doubts about that here. Even if you buy Eggertsson Woodford, their extended-period arguments are a matter of fulfilling a commitment, not getting some extra accommodative mileage currently. People who use the Eggertsson-Woodford argument are imagining the extended period to be well off in the future, not where we are now.

But one view of the Fed's behavior could be that it has simply lost its inflation resolve. If that view catches on, look out.


  1. "But one view of the Fed's behavior could be that it has simply lost its inflation resolve. If that view catches on, look out".

    Does that mean: look out for higher CAPEX, lower unemployment and higher GDP growth, as well as higher consumer confidence?

    If so; That sounds pretty good to me.

    1. No. There is a view out there that a good policy would be to create more inflation now - above 2% - or, failing that, get people to believe that there will be more inflation in the future (the latter is in part how Eggertsson-Woodford works). Either way, these people believe in a short-run Phillips curve, and they think they can exploit it. In the 1970s, some policymakers thought the same thing, and that got us into trouble.

    2. In the 1970s, some policymakers thought the same thing, and that got us into trouble.

      Yeah, they let the Arabs get away with an oil embargo. Have you not become a neo-con on Romney's foreign policy team?

      Returning to economics, Dean Baker just wrote:

      "The difference between a saving rate of 5 percent of disposable income and 0 is $500 billion in annual demand. Added to the $300 billion of missing demand from the residential construction sector, we need $800 billion or 5.4 percentage points of GDP, in additional demand from other sectors of the economy.

      While the Romney crew might sing the praises of the job creators, only in Republican fantasy land could this demand possibly come from investment. There continues to be substantial excess supply in most categories of non-residential real estate, which leaves investment in equipment and software as the only source for additional demand any time soon. This sector of the economy has averaged less than 8 percent of GDP through the last four decades. It would take a real wild investment boom to see this share rise enough to fill the gap created by the collapse of the bubble, especially considering the large amounts of excess capacity in many sectors of the economy.

      So, but for printing money, from where is demand going to spring?

    3. "So, but for printing money, from where is demand going to spring?"

      So, tell me how this money printing works to give us this "demand." How much demand do we need, and why, and how does the mechanism work?

      By the way, why all this talk about Republicans and neo-cons?

    4. How exactly does one observe "excess supply"?

    5. 1. Prices got away in the 1970s due to oil (Arab Oil Embargo, remember). Your criticism of 1970s policy makers therefore, by definition, makes you a republican neo-con.

      2. We have about 20% of our population, at best, un-employed, under-employed, or badly mis-employed, so we have a huge labor surplus to put to work.

      We obviously do not presently have enough money with which to do such sans some radical change in velocity.

      Since mankind built the Pyramids, the way idle resources have been put to work is through finance, either through credit creation of money or enforceable contracts of future promises or both. In sum, our current situation is a failure of finance and I believe such is at the micro level.

      Based on 35 years of observing banking first had, I would argue that finance's failure is at the micro level. Bank lending is too risky for borrower and lender and has been for many many years (hence the demand for safe assets). I would attack the problem from two directions.

      First, making it a lot less risky for borrowers to borrow by making all business loans non-recourse, permitting merchant banking, equity kickers, etc etc. This would include changing the bankruptcy laws to make such a revolving door sans sanction or damage to reputation (look at Silicon Valley which is about the only place on earth that sometimes rewards failure. CA is a non-recourse state) We need that everywhere.

      Second, we need to accelerate recognition and writing off of losses, without penalty on the lender. I would break all banks up to no more than $1 billion in assets and make them all private and then have the gov't provide matching renewable equity against which bad loans can be written off sans penalty. This would provide powerful incentives for banks to get really good at lending to small businesses. Since all money is green, lenders would have to provide services with their money and I would permit them to provide any lawful service, all to make these thousands of banks extraordinary drivers of entrepreneurship

    6. SW, Munger really describes your failures as an economist in his Psychology of Human Misjudgment. You are a man with a hammer (i.e., with one idea). I took the time to lay out a micro foundation way of looking at our problems and because you don't have the intellectual tools and depth to consider such your say nothing.

      Tom Peters recently wrote:

      If there is a single tragic flaw that mars our biggest enterprises, it is conservatism -- the failure to fail, and fail big, in an era of unprecedented volatility and ambiguity. In a chaotic world, your strategy must be chaotic enough (sufficiently failure-strewn) to up the odds of keeping pace with the times.

      My argument rests on such insights.

      Commercial banks have all the money in the world but are not lending. In such circumstances the micro foundations of lending have to be a suspect.

      Your New Monetarist Economics is BS until banks can make loans on terms and conditions that afford appropriate opportunities for borrowers and banks to profit

      Banks keeping telling us by their conduct (laying off thousands of employees) and demanding to be allowed to trade on their own account, that traditional banking doesn't work, today, at the micro level.

      We just experience the failure of every commercial bank in the United States. I don't know of a single commercial bank that would have survived 2007-08 but for the Gov't, except a newly chartered one with no loans.

      You have been writing Blah, Blah, Blah for over 5 years of this Depression and have never talked about this most basic question. Is Tom Peters right. Has the business world become such that our familiar model of commercial banking is not capable of dealing with the scale of risk that both borrowers and lenders are required to take.

      I keep returning to a simple question. Who in their right mind would borrow money today for any new venture that could create a job?

      That you have no answers . . .

    7. John D, you're still not fooling anyone.

    8. Anonymous, this John D. guy runs you around in circles.

      What he shows is that neither you nor SW are fooling anyone

      We all pity your students

  2. Scott Sumner has a post on the 1930s with some internal notes from the Fed. They resisted loosening the money supply in part because they didn't want to admit they were wrong before. That's part of his interpretation of their currently dysfunctional policy.

    If people think the Fed is going to fall down on inflation, that should show up in TIPS spreads.

  3. I think we should judge the Fed's current policy based on the market's inflation forecasts, which remain low by historical standards.

    The 5 year breakeven TIPS spread is about 2.2% and the Cleveland Fed's 10-year expected inflation estimate is well below 2% as of October 16.

  4. This result is very sensitive to the time window. Use 1997-2007 or even 1992-2007 and the implied fed funds rate get significantly negative in and after the most recent recession. But I am sure that Steve is aware of that...

  5. My concern is that, even though unemployment is down to 7.8% from about 9% a year ago (Septembet to September), the employment to population ratio is actually down from a year ago. While 2 million more people are employed, the increase in employment is too slow relative to the growth of population. A simplistic Taylor does not take into account these details.

    1. If you accept an activist role for the Fed in managing real activity, you would not be confining attention to the unemployment rate. Unfortunately much of the policy rule talk, not only about
      Taylor rules, but "liftoff" (e.g. Kocherlakota and Evans) is only about the unemployment rate.

  6. I think the FED clearly wants to continue QE, and are emphasizing the arguments in favor. We have the same thing in the UK with the BoE.