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Some thoughts on that new Fed paper everybody’s talking about.

Summary:
It’s a lovely morning on the back porch, and the mind turns to that new Fed study everybody’s talking about. It’s the one by Erceg et al about monetary policy at moments like this one, with a flat Phillips Curve (PC), u

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It’s a lovely morning on the back porch, and the mind turns to that new Fed study everybody’s talking about. It’s the one by Erceg et al about monetary policy at moments like this one, with a flat Phillips Curve (PC), u<u*, along with much uncertainty about u* (importantly, I’d argue that uncertainty is asymmetric; the Fed’s estimate u* looks too high). BTW, ‘u’ is the unemployment rate; ‘u*’ is the estimate of the “natural rate,” the lowest rate associated with stable prices.

I’ve got a longer, less cryptic piece on this study coming out later this week in WaPo (tomorrow, it’s Dean Baker and I celebrating Labor Day with a piece on unions as a potent weapon against inequality). But I wanted to set the table for that piece with a bit of analysis here. The WaPo piece explains any oblique terminology; apologies in advance for any obscurities in what follows.

One reason this piece, which I found to be a thoughtful/useful bit of work, is getting a lot of attention is because its key finding is counterintuitive. Given that unemployment has been well below the Fed’s estimate of u* of 4.5% and inflation’s (PCE core) just now hitting their 2% target, many of have argued that the optimal monetary policy is to downweight the unemployment gap and focus on the lack of wage or price inflation.

Consider, e.g., the strong version of this view from EPI’s Josh Bivens: “…the definition of labor market slack is wage growth too weak to put upward pressure on the Fed’s price inflation target. If this wage growth is not happening, there is labor market slack. So, simply looking at some quantity-side measure of the labor market (say the unemployment rate) and thinking ‘hmm, that’s low, we must be at full employment” is substituting gut feeling for economic reasoning.’”

In a similar vein, Baker and I have argued that you know you’re at full employment when extra demand generates not jobs and real wages, but inflation.

But the Fed study comes to a different conclusion, arguing that even if u* is uncertain, it’s “better” to target the employment than the inflation gap. The definition of “better” is key, of course, and the authors are explicit that their definition bakes in their result in ways with which reasonable critics may disagree (more on that in a moment).

The paper does a bunch of macrosimulations of unemployment and inflation outcomes using a set of monetary rules that apply stronger or weaker weights to the employment and inflation gaps. The find that “because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.”

This is interesting. While camp Bivens sees the combination of the flat PC and overestimated u* as a reason for accommodative monetary policy, their simulations suggest that because of the flat PC, over-weighting the inflation gap will lead to wide and damaging (to demand) swings in monetary policy.

In fact, conditions in the current economy partially drive their result. Suppose the Fed listens to team Bivens and targets inflation instead of unemployment. Because inflation has long undershot the Fed’s 2 percent target and the PC is so flat, it would take historically very low unemployment to juice inflation. Conversely, suppose some shock to the system…like, um, a trade war…led inflation to spike; then, the authors argue, it would take really high unemployment to bring inflation back down.

The study’s simulations thus find that if the Fed weighted up its inflation target relative to its unemployment target, the jobless rate could fall so low or climb so high that it could generate “risks to financial stability and more generally to the sustainability of macroeconomic outcomes.”

One way they end up there is by scoring success through a “loss function” that penalizes policy makers for letting the jobless rate fall below u*. But with u* higher than it should be, this approach doles out undeserved penalties for running a hot labor market (when they plug in a u* of 3.7%, upweighting the employment gap looks less favorable; compare Table 3, column F, rows 3 and 6). Their symmetric loss function (being below u* is as bad as being above it) also discounts the extremely valuable benefits of super-tight labor markets to less advantaged workers, a benefit that is especially worth tapping right now given the lack of price pressures. I’d want a loss function to reflect these benefits, one that treats being below u* as preferable to being above it.

As noted, the authors are explicit about this point, and the loss function they use is standard fare. Still, the paper is replete with so many variants, why not add one more? I urge the authors to run the results through a loss function that meets the criteria just noted.

I’ve got two more objections to the findings.

First, at least as I read it, the paper seems to suggest the Fed is unable to look past inflation perturbations caused by supply shocks. As just noted, the simulations appear to combine this inability with the flat PC to generate sharp, yet unnecessary (because it’s a temporary shock, not a shift in demand), accommodation or tightening. But this seems demonstrably wrong, as just recently, Fed statements have been replete with references to temporary shocks to prices, including energy, cell phone pricing, and Trump’s trade mishegos (the latter of which could eventually whack demand).

Also, what about all those years of hard work by Fed officials to anchor expectations? That too leads people to look through shocks and assume stable, long-term prices. (See the bottom panel of Figure 1 for evidence of well-anchored inflation expectations.)

Second, in numerous places, including the quote above, the paper argues that it’s better to be a bit more hawkish to avoid financial instability. This seems like step backwards. Former Chair Yellen and others have been very clear on this point: when we use tighter monetary policy to regulate bubbles in financial markets, we penalize the great many to hold back the reckless few. It is macroprudential policy and Dodd-Frank style regulation that should be the first line of defense against excesses in financial markets.

I get that Powell recently (wisely) argued that the Fed should put financial excesses high on its watch list. But, if the real economy is not overheating, that doesn’t imply that fighting them with higher rates is preferable to regulation, “irrational-exuberance”-style forward guidance, and higher capital buffers.

That said, I strongly recommend the paper to those of us calling for heavier relative targeting of inflation as opposed to employment. It offers some high-calorie food for thought.

Jared Bernstein
Jared Bernstein joined the Center on Budget and Policy Priorities in May 2011 as a Senior Fellow. From 2009 to 2011, Bernstein was the Chief Economist and Economic Adviser to Vice President Joe Biden, Executive Director of the White House Task Force on the Middle Class, and a member of President Obama’s economic team. Prior to joining the Obama administration, Bernstein was a senior economist and the director of the Living Standards Program at the Economic Policy Institute, and between 1995 and 1996, he held the post of Deputy Chief Economist at the U.S. Department of Labor.

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