Federal Reserve Nominal GDP Growth Undershoot Episode VII: The Undershooting…: Wednesday Focus: May 21, 2014

Et tu, Alan? When I read things like this, I become deeply, deeply depressed…

As a piece of Fed watching–a description of what the Federal Reserve as currently constituted is likely to do–this is, as you can rely on Alan Blinder to be, excellent: clear, insightful, accurate, illuminating:

Alan Blinder: Alan Blinder: Fed Hawks vs. Doves: The Sequel: “Once the Federal Open Market Committee (FOMC) announces a few more $10-billion-a-month ‘taperings’ of asset purchases…

…the financial markets will fixate completely on the Federal Reserve’s eventual “exit” from its current extraordinarily easy monetary policy…. When will this happen? My guess is around July 30, when the FOMC reduces its monthly purchases to $25 billion…. It will probably be accompanied by a revival—likely a loud revival—of the hawk-dove wars at the central bank. Right now, an uneasy truce prevails, as everyone has signed on to the strategy of gradual tapering. That truce won’t last. The FOMC will have to figure out how and when to exit from two main policies: its near-zero interest rates and its bloated balance sheet (which should be around $4.5 trillion when the asset purchases end).

Hawks and doves will do battle over three main issues:

1. How long should the Fed wait between the end of tapering and the beginning of exit?….
2. How fast and how high should interest rates rise?…
3. How quickly should the Fed’s balance sheet shrink?…

Former Fed Chairman Ben Bernanke often expressed the view that the Fed’s portfolio can shrink fast enough through natural roll-off, as securities mature and are not replaced. The new chair, Janet Yellen, has not yet spoken to that point. But I’ve always doubted that roll-off would be enough; my guess is that the Fed will have to engage in active selling. Which is hardly the end of the world…. I want to make three important points about the Fed’s eventual exit….

1. Both the starting point of the exit and the pace at which it proceeds will be largely determined by the economy. If the economy starts booming or inflation shoots up, the exit will go faster. If economic growth continues at the languid pace of the recovery to date (a paltry 2.2% per annum) and inflation remains low, the exit will be slower….
2. If we take the Fed’s goal to be a perfect soft landing at exactly 2% inflation and unemployment between 5.2% and 6% (the Fed’s official targets), then the central bank will definitely fail…. The Fed will surely err. Its job is to get us out of this mess with only modest errors rather than huge ones….
3. The Fed could miss in either direction…. We could wind up with inflation well above 2% and rising…. But… the premature tightening of monetary policy could kick the still-crawling economy down the staircase again… unemployment above 6% and inflation below 2% and perhaps falling. You don’t hear much about that scenario these days, but you should. It’s what worries the doves….

A dumb, incompetent or overly-political Fed could make colossal errors that inflict great harm on the U.S. economy. Critics, especially on the right, seem to cast the Fed in this light. I don’t. The major components of exit are clear enough, and the Fed has already articulated crucial parts of its exit strategy…. Even a smart, competent and apolitical Fed will make some errors along the way; but they should be small, manageable and correctable. Fortunately, we have a smart, competent and apolitical Fed.

As I said, as a piece of Fed watching–a description of what the Federal Reserve as currently constituted is likely to do–this is, as you can rely on Alan Blinder to be, excellent: clear, insightful, accurate, illuminating. But in the last paragraph it switches from being simply Fed-watching to one of applause and approval for the Federal Reserve’s current course. And that I cannot endorse, for in so doing Blinder sweeps under the table the information in the following three graphs:

Now it may be that a year from now will not be too soon for the Federal Reserve to begin raising short-term safe nominal interest rates. It may be that the Federal Reserve’s failure to understand in late 2009 the likelihood of a slow, anemic, jobless recovery and its acquiescence in a decline in both the trend level and the trend growth rate of nominal GDP have had consequences that have been leaked out from the short run to the medium run: it may be that a great deal of what was cyclical unemployment has turned structural, and that we should not look at GDP or employment relative to pre-2008 trends but instead accept the unemployment rate has our best indicator of the cyclical slack remaining in the economy. In that case, Federal Reserve policy is appropriate, and Blinder is correct in commending it.

But it is equally–or more–likely that it is the unemployment rate that is awry as a gauge: that a great many of those who call themselves out of the laborforce are indeed near the tipping point and would reenter the labor force if wage growth were a little bit faster and job a little bit easier to find.

How can we learn which is correct? The only way is to follow the example of Rikki-Tikki-Tavi the cobra-hunting mongoose: Run and find out! That is what Alan Greenspan did with the Federal Reserve in the mid 1990s when there was genuine uncertainty about whether the information technology revolution had sped up the growth rate of potential GDP and, at least for the moment, lowered the natural rate of unemployment. He ran and found out. Optimism proved correct. The last half of the 1990s were–as Alan Blinder and Janet Yellen called them in the title of their book–fabulous.

If I were running the Federal Reserve right now, I would say that there is great uncertainty as to how much damage has been done to the economy’s long-run growth potential by the housing bust, the Greater Crash of 2008-9 that followed it–hey macroeconomic shock it was, as I can green and O’Rourke have shown, greater than the one that started the Great Depression–and the jobless recovery of 2009-14 that has followed it and given America it’s own Lost Decade and Lesser Depression. I would say that it is the policy of the Federal Reserve to run and find out: to postpone tightening until the price level recovers to its pre-2008 trend, and that after the price level recovers the Federal Reserve Will resume its inflation-targeting regime.

(Christina Romer would, I think, go further: she would, I think, call for the Federal Reserve to explicitly shift its policy to targeting nominal GDP along nominal GDP’s pre-2008 growth path. I am, at least in the context of the south wing of the sixth floor of Berkeleys Evans Hall, A relatively conservative shadow central banker.)

Yet, as has been the case since the mid-2000s, the Federal Reserve’s Open Market Committee has few or no voices on the activist side of its consensus policy path when it’s extremely heavy weight on the price-stability part of the dual mandate. And this has meant that since the mid 2000 Federal Reserve’s Open Market Committee has been far behind the curve with the actual course of future events rarely considered even as unlikely scenario.

And without going all Rikki-Tikki-Tavi–without running and finding out–how will we learn whether the FOMC over 214-16 is continuing its serially correlated errors of policy or not?