Must-Read: Ryan Avent: Absence of Evidence: The Fed Rethinking One Thing too Many

Must-Read: Ryan Avent: Absence of Evidence: The Fed Rethinking One Thing too Many:

OFFICIALS at the Federal Reserve, a few of them anyway, seem to be rethinking their views of the economy in some dramatic ways….

Ben Bernanke suggests… top policy-makers still have confidence in their mental model of the economy; they have just been tweaking a few of the parameters… long-run… GDP growth… unemployment… and their benchmark interest rate…. The latter two [what I call (1) and (2)]—a lower unemployment rate and a lower long-run interest rate—clearly imply that rates will rise more slowly to a lower overall level. The projection of a lower potential growth rate [what I call (5)], however… suggests, for instance, that the American economy is running closer to its “speed limit”… push[ing]… toward a more hawkish stance…. These three revisions are not created equal…. [(1) and (2)] are clearly justified…. [(5)] is different, however. Available evidence is consistent with a world in which long-run potential growth has fallen… but… also… with an economy… growing slowly because of too little demand… in which both strong employment growth and low productivity growth are side effects of the low level of wages.

The only way to resolve the question in a satisfying way is to test it: to push the economy beyond the estimated potential growth rate and see if inflation rises…. Bernanke argues that Fed officials are willing to be a little patient with the economy, to see whether running it a little hot brings more workers into the labour force and encourages productivity-enhancing investments. It certainly seems clear to me that overshooting is the right way for the Fed to err….

But I am less confident than Mr Bernanke in the Fed’s openness to overshooting. It did not exactly intend to run the unemployment rate experiment that demonstrated how run its previous projections had been…. Now, the Fed looks all too willing to revise down its GDP growth projections without ever really testing them…. There is far too little radicalism at the Fed. It risks making permanent a low-growth state of affairs which is largely a consequence of its own excessive caution.