The Fed is planning for failure
By Scott Sumner
Over at Bloomberg.com, Narayana Kocherlakota has a nice post discussing the Fed’s plan for the next recession. He provides some graphs showing alternative policy paths:
She [Yellen] views this black-line outcome as a demonstration that the Fed’s existing tools would be “sufficient” (to use her word) for the Fed’s purposes.
It’s worth thinking carefully about Yellen’s statement. The black line in the bottom left panel shows that the unemployment rate would remain above 5 percent for four years. The black line in the bottom right panel shows that the inflation rate would be below the Fed’s target of 2 percent for more than a decade.
Two years into this hypothetical recession, the Fed would be refusing to provide more accommodation, even though the unemployment rate would be above 9 percent and it would be expecting the inflation rate to be falling further below its target for another three years. (And as I have written, at this point in the recession, the unemployment rate among blacks would likely be above 17 percent.)
How can the Fed view these unemployment and inflation outcomes as acceptable? One answer is that the Fed can’t do any better. But inside the model used to generate Yellen’s slide, the Fed can always push down the unemployment rate and raise the inflation rate by promising to keep its target interest rate lower for longer, buying more long-term assets or both.
The inflation and unemployment outcomes depicted by Yellen represent the Fed’s desires (as modeled by its staff), not its limitations. (Indeed, elsewhere in his paper, Reifschneider depicts how the Fed could do significantly better.)
Kocherlakota is right, and indeed in some ways understates the problem with this plan.
1. Notice that the Fed anticipates that both employment and inflation will decline during the next recession. That means they expect the next recession to be caused by an adverse demand shock. And that means they expect that the cause of the next recession will be . . . the Fed itself.
2. This policy is also inconsistent with the Fed’s dual mandate. Imagine they had a single mandate, inflation targeting. In that case, they would put no weight on employment fluctuations. If you now add employment to the Fed’s mandate, then they need to have a more expansionary policy that otherwise when unemployment is high, and vice versa. But under the Fed’s plan, they actually plan to have a tighter monetary policy than what would be called for under a pure inflation target, during periods when unemployment is extremely high. This is simply perverse.
Instead, the Fed should be aiming for above trend inflation during periods of high unemployment, and vice versa. That’s not just a good idea, it’s the law.
Under nominal GDP targeting, the Fed would push inflation above 2% during recessions, and below 2% during booms. The average would still be 2%, but there would be less volatility in real output. The best way to do this is to always set policy at a level where 12 month (or perhaps 24 month) forward NGDP expectations are exactly on target.
In the graphs above, the Fed assumes that inflation is 2% before the recession, and 2% after the recession. During the recession itself, the inflation rate is considerably below 2%. But that means the average inflation rate will be below 2%, and the Fed has recently assured us that the 2% target is symmetrical; a midpoint, not a ceiling. So why produce hypothetical graphs that make it look like a ceiling?
Under NGDP targeting, inflation might run about 1.5% during a boom, and then rise to 2.5% during a recession. That sort of countercyclical inflation will tend to stabilize the labor market, and also the credit markets.
The BoE’s recent moves to ease policy have produced expectations that British inflation will rise and RGDP growth will decline in 2017. I don’t know if that will occur, but at least in terms of market expectations, the BoE is on the right track—always aim for countercyclical inflation.
The Fed often uses the Phillips Curve to forecast the economy. But the Phillips curve only works when inflation is procyclical. So the Fed uses a forecasting tool that is only useful when Fed policy is destabilizing to the economy. Thus I believe things are far worse than even Kocherlakota suggests. The Fed needs to rethink policy from the ground up.
One place to start is with their assumptions about the stance of monetary policy. Kocherlakota links to a Fed paper that included the graphs above, and also this one:
That graphs show a tight policy during 1979-81, and a very easy money policy since 2009. Back in 2003, Bernanke said the best way to ascertain the stance of monetary policy is to look at NGDP growth and inflation. I agree. By those criteria, policy was wildly expansionary during 1979-81 and very contractionary after 2009.
As long as the Fed doesn’t know where it has set the steering wheel, it’s not likely to be able to reach its preferred destination.