Evening Must-Read: Monetary policy: A Few Points on Slack

MOAR on the “slack” debate: Ryan Avent: Monetary policy: A few points on slack: “A DEBATE has broken out over just how close America is to full employment

I recommend comments on the subject from Tim Duy and Cardiff Garcia. I’ll make a few points…. 1) The labour market is tightening, as it has for at least the last two years, but it is objectively not tight…. 2) Having said that, we are approaching the point in the business cycle at which the Fed would historically begin tightening…. 3) There is some concern that there is less slack in the American economy than we would normally expect at an unemployment rate of 6.7%…. 4) The question is, should the Fed begin tightening at this point in the slack cycle?5) Wait, that’s not the right question at all! 6) The real question is, why, nearly five years into a recovery from the worst recession of the postwar period, with labour markets looking as bad as in the worst moments of most recent recessions, with full employment another year or two away, with inflation well below the official target, and with interest rates at the zero lower bound: why is the Fed not figuring how to accelerate the recovery? 7) And then, actually, the real question is why the real question, at least where most pundits are concerned, is… (4) rather than… (6). Answer that and you have a pretty good idea why the labour-market recovery has been so awful.

8) Because one can mount a pretty good argument that when the Fed tightened at this point in previous cycles it was acting too hawkishly…. 9) But setting all of those arguments aside, the fact that the American economy is at the zero lower bound should fundamentally change the way that we approach this question…. 10) First, when an economy is stuck at the zero lower bound, the central bank can only provide further stimulus… by raising inflation expectations…. 11) Second, if the Fed tightens as it normally does so as to prevent any inflation overshooting, then it will continue the long-run downward trend in nominal interest rates…. 12) Third, and this is where things get really nasty, the Fed’s puzzling choice to behave as if nothing odd happened over the past 7 years will make it harder to provide stimulus after the economy hits the zero lower bound in the next recession….

The main point is this: we don’t know exactly how much of an output gap there is in the economy. But we have a good idea what the balance of risk looks like. When the Fed allows the economy to operate with slack for long periods of time, that translates into trillions of dollars in lost output and considerable human suffering. When the Fed overshoots on inflation there is some economic cost from relative price distortions—but when that overshooting occurs while an economy is at the zero lower bound those distortionary costs are mostly if not entirely offset by reduced probability of future output losses from inadequate monetary policy. If your moral calculator runs those numbers and concludes that the Fed should behave as it usually does so as to avoid overshooting on inflation, throw your moral calculator in the lake and buy a new one. That’s the main point.