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:
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:
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:
What about growth in real GDP?
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):
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.
Steve, in this post as well as in chapter 15 of your textbook you make clear that traditional monetary policy prescribes the wrong response of the nominal interest rate to inflation. The math, based on the models, proves you are right. But there is another possibility: that the models are wrong themselves. Most people interpret the data as supporting traditional monetary policy. For example, in the early 1980s the interest rate went up before inflation went down. Yes, the nominal interest rate eventually fell, but that was following the drop in inflation. Similarly, the effective Fed Funds rate increased from 2004 to 2006 and core CPI inflation started to fall in 2006, just when the fed funds rate had peaked, and its decline followed that of inflation. In any case, I understand that there are a lot of endogeneity issues, but surely there must be a way to empirically test whether the Neo-Fisherians or the central bankers are correct, no?ReplyDelete
"Most people interpret the data as supporting traditional monetary policy."Delete
That is, "most" people think in terms of static IS/LM with fixed expectations, and they want to interpret monetary policy as working that way, no matter what they're seeing in the data - or they will claim that the data is consistent with their views.
The most obvious natural experiment that's inconsistent with that view is the previous 22 years in Japan. If the conventional view were correct, then eventually inflation in Japan should have gone up, and it didn't. The Volcker deflation is consistent with the neo-Fisherian view, as Volcker conducted a monetarist experiment - he reduced money growth, and inflation went down. The path the nominal interest rate followed in response to that policy is consistent with a policy response to a nominal interest rate reduction of inflation going down. If you're looking for empirical evidence, there's the VAR evidence, if you want to take that seriously. In that literature, people were always finding a "price puzzle," and they went through various specification searches to try to get rid of it. The price puzzle is just a neo-Fisherian response - nothing puzzling at all.
Well, yes, VARs have to be taken with a grain of salt, but nevertheless I thought that the price puzzle goes away if one allows for monetary policy lags as in Estrella (2015) or accounts for the fact that the Fed may be better able to forecast future inflation as in Cloyne and Hurtgen (2016).Delete
Right. If you do a specification search, you can find a specification for which the sign reverses. Sufficient time searching also produces a Phillips curve with large T statistics where everything has the right sign.Delete
I suppose the question is if one thinks that specification is reasonable or not. Don't you think the aforementioned have a point?Delete
After the fact, one could make a case of "reasonableness" for almost anything.Delete
"... the labor market is extremely tight.." No it is not, not based on recent history. The participation rate is still down 2.5% from Jan 1999 for the 25-54 yr old cohort. The employment to Population Ratio is down 3.5% from May 2000 for the 25-54 yr old cohort. There is still at a lot of slack in the labor market.ReplyDelete
It must then be the case that the labor market got continuously tighter from 1950 to 1999, as the participation rate for those 25-54 rose over that period. Or maybe the labor market for men has continuously slackened since 1950, as epop for men has fallen substantially on trend since then. I hope you understand that we can't determine what's economically efficient by looking at the max over the last 60 years, or some such.Delete
I believe we can look at recent history to inform us of what is going on. The 90s experience tells us what the market can absorb in terms of people in the labor market. The fact that automation and off-shoring reduce the number of jobs that are required for the economy to function doesn't preclude the fact that people need a job to survive, employers are exploiting that fact at the moment to keep wages suppressed. If the labor market were really tight wages would be rising substantially faster than they are.Delete
Employers also need workers in order to survive. So why aren't the workers exploiting the employers? But, if employers are somehow conspiring to keep wages low, why are the employers posting all those vacancies? Maybe that's part of the conspiracy as well, just to cover their tracks?Delete
I never said anything about a conspiracy - I was just stating the power balance that exists. We know the power is with the employers at the moment because they are not offering substantially higher wages to prospective employees. I will believe we have an "extremely tight" labor market when wage inflation gets above 5 percent. As it is wage inflation is just about getting to the lowest levels triggered by the 2001 recession.Delete
I don't think that wage growth is out of line with productivity growth. There's no evidence that workers' bargaining position has worsened.Delete