What Should Monetary Policy Be?: Thursday Focus for September 25, 2014

Chicago Federal Reserve Bank President Charles Evans’s position seems to me to be the position that ought to be the center of gravity of the Federal Open Market Committee’s thoughts right now, with wings on all sides of it taking different views as part of a diversified intellectual portfolio. Charles Evans:

Charles Evans: Patience Is a Virtue When Normalizing Monetary Policy: “At the end of the second quarter of 2014…

…the labor force participation rate was between 1/2 and 1-1/4 percentage points below trend… as much as 3/4 of a percentage point below predictions based on its historical relationship with the unemployment rate…. Virtually all the gap during this cycle has been due to withdrawal from the labor market of workers without a college degree…. If skills mismatch were an ongoing problem, we’d expect to see wages rising for those with the skills in demand…. Pools of potential workers other than the short-term unemployed, notably the medium-term unemployed and the involuntary part-time work force, substantially influence wage growth at the state or metropolitan statistical area level…. Current circumstances and a weighing of alternative risks mean that a balanced policy approach calls for being patient in reducing accommodation…. The biggest risk we face today is prematurely engineering restrictive monetary conditions…. If we were to… reduce monetary accommodation too soon, we could find ourselves in the very uncomfortable position of falling back into the ZLB environment…. There are great risks to premature liftoff…. And the costs of being mired in the zero lower bound are simply very large…

Yet Evans is out there on his own–with perhaps Narayana Kocherlakota beside him.[[3]][3]

As I see it:

1. The past decade has demonstrated that to properly reduce the risks of hitting the zero nominal lower bound on safe short-term interest rates, we need not a 5%/year but at least a 6.5%/year business-cycle peak safe short nominal rate.1 With a 3%/year short-term peak real natural interest rate, we need not a 2%/year but a 3.5%/year inflation target instead.

2. It is likely that the safe natural real rate of interest has fallen by 1%-point/year. That means that a healthy economy properly distant from the ZLB requires not a 3.5%/year but a 4.5%/year inflation target.

3. It is very important when the economy hits the zero lower bound on nominal interest rates that expectations be that the time spent at the ZLB will be short. To build those expectations, it is important that when the economy emerges from the ZLB it undergo a period in which the long-run inflation target is overshot.

4. The likelihood is that downward movements in labor force participation that are cementing into structural impediments to employment can be reversed if high demand pulls workers back into the labor force before the cement has set, but only with difficulty otherwise. The benefit-cost analysis thus calls for an additional inflation overshoot in order to satisfy the Federal Reserve’s dual mandate.

5. If the Federal Reserve aims at a 2%/year inflation target and fails to raise interest rates sufficiently early, it may wind up with 4%/year inflation and have to raise short-term real interest rates to 6%/year–a nominal interest rate of 10%/year–to return the economy to its inflation target. If the Federal Reserve prematurely raises interest rates, it may wind up with 0%/year inflation and wish to lower short-term real interest rates to -2%/year to return the economy to its inflation rate. With inflation at 0%/year, it cannot do that. Thus the risks are asymmetric: raising interest rates later than optimal under perfect foresight carries much lower risks than does raising interest rates earlier than optimal.

6. Since 1979 the Federal Reserve has built up enormous credibility as the guardian of price stability and has wrecked whatever credibility it had as the guardian of low unemployment. A situation in which the general expectation is that the Federal Reserve will do too little to guard against high unemployment is worse than a situation in which the general expectations is that the Federal Reserve will too little to guard against inflation–“it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier”.2

7. The PCE price index is now undershooting its pre-2008 trend by fully 5%: the proper optimal-control response to a large negative real demand shock is not a price level track that falls below but rather one that rises above the previously-anticipated trend path.

IMHO, you need to reject all 7 of the above points completely in order to think that the FOMC’s goal of returning inflation to 2%/year and keeping it there is anywhere close to an optimal-control path for an institution governed by its dual mandate. I really do not see how you can reject all seven.

Moreover, financial markets right now believe that the Federal Reserve’s policy is not going to attain 2%/year inflation–not now, not over the next five years. Since June the on-track-to-recovery Confidence Fairy–to the extent that she was present–has flown away:

Thus right now justifying the Federal Reserve’s policy track seems to me to require rejecting all seven of the points above, plus rejecting the financial markets’ read on monetary policy, plus rejecting the consideration that depressed financial markets–even irrationally-depressed financial markets–should be offset with additional demand stimulus.

Yet only two of the seventeen FOMC participants are with me. Am I off my rocker? Have they been consumed by groupthink? How am I to understand all this?

[3]: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140917.pdf (Percent
Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, September 2014: Advance release of table 1 of the Summary of Economic Projections to be released with the FOMC minutes)

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