What Is Going on with the Federal Reserve?: Watching an Ongoing Discussion

With unemployment above and inflation below its formal targets, Why is the Federal Reserve talking about withdrawing stimulus? Why is it talking about moving to a regime in which it is no longer purchasing long-term securities as part of quantitative easing? And why is it forecasting that it will begin to increase interest rates six months after quantitative easing ends?

I cannot say that I understand what is going on. Here we have some smart people who also do not understand what is motivating Federal Reserve policy gnawing at the problem–plus we have Janet Yellen saying that there is still an awful lot of slack in the American labor market.

• Janet Yellen says that there is plenty of labor-market slack…
• Jared Bernstein says that Janet Yellen is wise…
• **James Hamilton thinks the approaching end of further quantitative easing is the right course…
• Ryan Avent quotes Gabriel Chodorow-Reich to the effect that markets do not fear additional QE…
• Keven Drum on how 2014 will be a watershed year for the Federal Reserve to decide whether it is a technocratic institution or not…
• John Makin on how the Fed and the ECB need to move now to expand aggressively in order to preempt deflation…
• Kevin Drum on sources of inflation paranoia…

Janet Yellen: What the Federal Reserve Is Doing to Promote a Stronger Job Market: “If unemployment were mostly structural…

…if workers were unable to perform the jobs available, then the Federal Reserve’s efforts to create jobs would not be very effective. Worse than that, without slack in the labor market, the economic stimulus from the Fed could put attaining our inflation goal at risk…. This is not just an academic debate. For Dorine Poole, Jermaine Brownlee, and Vicki Lira, and for millions of others dislocated by the Great Recession who continue to struggle, the cause of the slow recovery is enormously important…. Now let me explain why I believe there is still considerable slack in the labor market, why I think there is room for continued help from the Fed for workers, and why I believe Dorine Poole, Jermaine Brownlee, and Vicki Lira are right to hope for better days ahead.

One form of evidence for slack is found in other labor market data, beyond the unemployment rate or payrolls…. Seven million people who are working part time but would like a full-time job. This number is much larger than we would expect at 6.7 percent unemployment…. Statistics on job turnover also point to considerable slack…. Likewise, the number of people who voluntarily quit their jobs is noticeably below levels before the recession; that is an indicator that people are reluctant to risk leaving their jobs because they worry that it will be hard to find another. It is also a sign that firms may not be recruiting very aggressively to hire workers away from their competitors.

A second form of evidence for slack is that the decline in unemployment has not helped raise wages…. Labor compensation has increased an average of only a little more than 2 percent per year since the recession, which is very low by historical standards….

A third form of evidence related to slack concerns the characteristics of the extraordinarily large share of the unemployed who have been out of work for six months or more. These workers find it exceptionally hard to find steady, regular work, and they appear to be at a severe competitive disadvantage when trying to find a job…. The long-term unemployed look basically the same as other unemployed people in terms of their occupations, educational attainment, and other characteristics…. This fact gives me hope that a significant share of the long-term unemployed will ultimately benefit from a stronger labor market.

A final piece of evidence of slack in the labor market has been the behavior of the participation rate….

Since late 2008, the Fed has taken extraordinary steps to revive the economy….

In this context, recent steps by the Fed to reduce the rate of new securities purchases are not a lessening of this commitment, only a judgment that recent progress in the labor market means our aid for the recovery need not grow as quickly. Earlier this month, the Fed reiterated its overall commitment to maintain extraordinary support for the recovery for some time to come.

This commitment is strong, and I believe the Fed’s policies will continue to help sustain progress in the job market. But the scars from the Great Recession remain, and reaching our goals will take time.

Jared Bernstein: Yellen Wisely Continues to Target Broader Measures of Labor Market Slack: “Janet Yellen appears to have solid intuition when it comes to the labor market slack….

There’s this debate going on that says “given all the slack in the job market, we should have seen inflation (price growth) fall a lot faster than it has.  Thus, maybe there’s not so much slack in the labor market.” This position got a bit of a boost from a recent paper by Krueger at al, which argues that if you just look at the total unemployment rate, you will mistakenly conclude that there’s more slack than there really is…. When asked about this the other day, Chairwoman Yellen called this line of argument “tremendously premature.”… Well, over the weekend I read an interesting piece by Goldman Sachs economists Hatzius and Stehn (H&S, no link) that tackled this question by digging a bit deeper in the current dynamics between unemployment and wages/prices.  Their key findings are:

• Starting around the 1990s, inflation fell and has stayed pretty low and well-anchored (meaning less responsive to temporary shocks);
• Thus, the Phillips curve—the reaction function between inflation and labor market slack flattened considerably….
• If you fail to account for this… you’ll overestimate its expected reaction to any given amount of slack.

Why the shift?  H&S say that “a likely explanation is that downward nominal rigidities are much more important at lower levels of inflation than at higher levels…. This may seem arcane but I assure you, it’s not.  Were the Fed to buy the short-term-rate-is-the-one-to-watch line, they’d conclude that instead of being biased down (as I and others have been stressing for months) the unemployment rate is biased up.  Thus, they’d be more likely to tighten prematurely.

Second, and Yellen was great on this point in a talk she gave today, to buy the short-term story implies some degree of writing off the long-termers…. “Yellen clearly comes down on the other side of the argument: ‘This fact gives me hope that a significant share of the long-term unemployed will ultimately benefit from a stronger labor market.'” That view is one I tried to amplify here, and it’s a view that underscores both the long-term costs of such persistent slack in the job market, as well as the potential benefits of pursuing a path back to full employment.

**James Hamilton: The effectiveness of unconventional monetary policy: “Rogers, Scotti and Wright (2014) reviews and updates evidence…

…from the experience of the U.S., U.K., Europe, and Japan, and concludes… that LSAP and forward guidance are potentially effective policies for easing financial conditions when the short-term interest rate is already near zero. Another new study by Hayashi and Koeda provides further evidence looking at the data in a completely different way. They note that during episodes in which Japan’s short rate was near zero, an increase in the level of excess reserves in month t tended to be followed by a higher level of output in month t+1.

There is thus considerable evidence that these unconventional monetary policy measures have some modest potential to help stimulate a struggling economy.

Less clear is what risks may be associated with unconventional monetary policy…. Why might the Treasury be reluctant to shorten its maturity structure? The answer is fairly obvious…. How are things different when the government’s short-term liabilities are in the form of overnight deposits with the Federal Reserve?… Although the mechanics of a flight from unwanted reserves would work differently from those for an undersubscribed Treasury option, it seems to me that the economic fundamentals are the same…. There would be nothing the Treasury or the Fed could do to avoid a spike in interest rates and a potentially very disruptive financial situation if lenders are no longer willing to continue to roll over what has effectively become a huge volume of overnight government debt.

It is of course inappropriate to be paralyzed by fear of such a scenario at the present moment, when interest rates and inflation are so low; any such problems will not arise until well into the future. But I also do not think it is inappropriate to dismiss these considerations entirely…. I think the current course signaled by the Federal Reserve– that growth of its balance sheet will end by the end of this year– is the correct one….

Ryan Avent: Free exchange: Staying unconventional: “New research suggests central bankers should be bolder and more innovative:

AFTER half a decade of bucking convention, the Federal Reserve is settling into more familiar routines. The central bank announced on March 19th that monthly bond purchases under its quantitative easing (QE) programme will be cut by $10 billion to $55 billion, starting in April. For many in the staid world of central banking it will be a relief: QE and other “unconventional” polices used when interest rates hit rock bottom in December 2008 have always been controversial. Yet a new set of papers released on March 20th at the Brookings Institution, a think-tank (and now home to the Federal Reserve’s previous chairman, Ben Bernanke), give a different view. Taken together, they suggest a return to monetary normality may be coming too soon.

Jitters about market bubbles are one reason the Federal Reserve is dialling down its bond buying. A new study by Gabriel Chodorow-Reich of Harvard University shows that since 2013 Federal Reserve committee members, including Mr Bernanke, have cited concerns over increased financial-sector risk-taking as a reason to mute QE…. But those worries wither under closer scrutiny, as Mr Chodorow-Reich shows. He starts his hunt for a link between QE and risk with banks and life insurers…. Markets, then, are not worried about QE, even if the central bank is…. An examination of over 500 MMFs shows they are taking a safer option, cutting their fees rather than increasing risk…. An analysis of balance-sheet data of over 4,000 pension funds concurs: despite extended QE and low interest rates, there is no sign of a dangerous search for yield.

Keven Drum: What’s Wrong With the Fed?: “In 2012, the Fed announced an inflation target of 2 percent per year…

…as measured by the PCE index. But they haven’t come close to hitting it. Why not?… I suspect the Fed really is having technical trouble meeting its goals—at least, in a way it’s comfortable with. But that’s just a guess. It’s less of a guess that the Fed is pursuing goals outside its mandate. It’s hardly a secret that there are plenty of Fed governors who are still living in the 70s, petrified of inflationary spirals and determined to keep inflation as low as possible. Not 2 percent. As low as possible. What’s more, they consider full employment not a virtue, but a threat. It leads to higher inflation, after all.

I think 2014 is something of a watershed year for the Fed. The hawks can argue that a single year of 1 percent inflation is nothing to worry too much about. This stuff bounces around. But at the very least, they should be on board with getting the inflation rate back up to their stated goal. Given the current employment level and the state of the global economy, this poses little risk. If they aren’t willing to do it, they need to come clean that they don’t really care about their statutory mandates and are simply substituting their own timeworn fears and class loyalties for the expressed will of Congress.

John Makin: Now is the time to preempt deflation: “The threat from deflation is not always obvious to either the general public or…

…apparently, the many policymakers who continue to dismiss the possibility of outright deflation. For the last several months, the Fed has treated the American drift toward deflation as temporary. In a March press release, the FOMC said:

The committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

The Fed’s presumption that inflation will move back toward 2 percent rather than drift lower is perhaps a dangerous one and certainly suggests an asymmetric concern about the pace of price increases at the Fed. With inflation actually having dropped below 1 percent on a trend basis, the Fed should be suggesting, as one dissenting member of the FOMC has, that inflation could drift lower and that it would take aggressive action to offset it. Surely the hawks would jump on a 3 percent inflation rate, as it is dangerously above the 2 percent inflation target.

The harsh reality, of course, is… it is not clear what the Fed could do to offset deflation, given that it is abandoning quantitative easing and forward guidance at a time when interest rates are locked at a level close to zero… [and] as the Fed persists in its modest tightening regime, its bias is for inflation to continue to drop rather than to increase. Given that the Fed has suggested that it will be able to withdraw stimulus over the next 18–24 months, it is clear that an assumption that inflation will somehow return to the 2 percent level while the Fed is tightening is embedded in FOMC thinking, evidence to the contrary notwithstanding.

The European Central Bank (ECB) has thus far taken no overt action to slow the pace of disinflation, which is taking year-over-year price changes perilously close to zero. Nor have the Chinese undertaken any extra overt measures given the undershoot of the inflation pace emerging in the Chinese data….

Leading policymakers—including those at the Fed, International Monetary Fund, and ECB—give two reasons for their complacency about deflation. First, they suggest that measures of expected inflation are well-anchored. Second, some argue that when actual inflation is between 0 and 2 percent, inflation expectations are in a quiet zone, not likely to change abruptly. There is little evidence for the latter assertion, while the former notion—well-anchored inflation expectations—is akin to the patient who delays taking the painkiller because he is not currently feeling any pain…. Japan’s experience with its drift into deflation during the 1990s can teach the US and Europe some lessons about complacency today….

Today’s actual year-over-year US inflation trend, as measured by the personal consumption deflator the Fed favors, is 0.9 percent…. The OECD forecast for US CPI inflation in 2014–15 is 1.8–1.9 percent. This optimism about a rapid inflation rebound looks distressingly similar to the OECD’s complacent view on Japanese deflation at the end of 1994…. Deflation is self-reinforcing for two basic reasons. First, when prices start to fall, the desire to hold cash is reinforced….

Many commentators have been surprised by the weakness of US investment spending during this weak recovery. Few have observed that falling inflation and the threat of deflation that boosts the real costs of borrowing may be to blame…. The complacency at central banks about the threat of deflation constitutes a necessary but not sufficient condition for deflation to appear…. The last example of global deflation was, of course, the Great Depression…. Policymakers need to undertake a global effort to combat the possibility of deflation. That requires a global commitment that includes both measures to prevent deflation from appearing and aggressive monetization as a means to preempt deflation…

Kevin Drum: Why Are We All So Obsessed With Inflation?: “Paul Krugman brings up a familiar trope this weekend…

…why is it that everyone is so obsessed with ultra-low inflation, even in the middle of a sluggish economy that would almost certainly benefit from a few years of 4 percent price growth? His answer: rich people are uniquely vulnerable to high inflation, and therefore fear it. And since rich people have tremendous influence on policy—especially economic policy—we’ve consistently implemented policies dedicated first and foremost to restraining inflation. Tyler Cowen dissents….

So what’s going on? My take has long been fairy simple: it’s mostly due to septaphobia, or fear of the 70s. It’s not actually true that the middle class was decimated by the 70s, but a lot of middle-class workers felt hard done by, especially since the price we all paid for the 70s was the traumatic Volcker recession of 1980-81. As for rich people, they really did suffer losses during the 70s as we made our rocky transition from an era of financial repression and fixed returns to our current era of global finance and variable returns. Central bankers belong in this story too: during the 70s, they developed a deep fear of their own inability to control wage-price spirals once inflation got above 2 percent or so…. Basically, the 70s are to modern publics what Weimar hyperinflation was to a generation of Germans: a scarring experience that forged a deep and broadly-held fear of inflation of any kind.

There’s so much inflation indexing in our modern economy—sometimes explicit, sometimes not—that inflation poses only a moderate threat to the rich…. That said, I don’t disagree that, in reality, elite opinion drives much of the inflation fear in the United States and Europe. It’s irrational, since the rich benefit from lower middle-class wages and a faster-growing economy, but that doesn’t mean it’s not real. Phobias are hard to cure.