Why it's hard to give good advice to the Fed
By Scott Sumner
This Washington Post story (by Ylan Mui) from a couple months back makes me kind of sad:
During the long recovery from the Great Recession, the central bank kept its benchmark interest rate at virtually zero and pumped trillions of dollars into the economy in hopes of fostering faster growth. Republicans lambasted the effort as creating potentially dangerous imbalances in the financial markets. Democrats backed the moves as essential to ensuring the nation did not slip back into recession.
But the dynamic has shifted since late last year, when the Fed, under Yellen’s leadership, raised rates for the first time in nearly a decade. Liberal economists — including some within the central bank — worried that the move was premature. Democrats who had hoped Yellen would keep the spigot of easy money flowing were getting worried.
So activists at the Center for Popular Democracy, a coalition of liberal groups, organized workers to protest in Washington and at the central bank’s regional branches across the country, then reached out to lawmakers and liberal economists to amplify their message. Seeded with money from Silicon Valley, the two-year-old organization has turned the effort, known as Fed Up, into a powerful vehicle for the liberal critique of the central bank.
The left has it all wrong. The period from late 2008 through the early 2010s was when the progressives should have been out marching in the street for easier money. It was an easy call, as money was far too tight. But they were silent.
Today there is a case for easy money, but it’s far weaker. The Fed’s target is 2% PCE inflation, and an unemployment rate close to the natural rate. Their most recent forecast is that PCE inflation will average 1.9% in 2017, and 2.0% in 2018 and 2019. So they have set policy at a position where they expect to hit their inflation and employment targets.
Now let’s look at some arguments for easing:
“The economy has recovered for much of white America. But for black and Latino workers, it hasn’t,” Fed Up member Rod Adams, a neighborhood organizer from Minneapolis, said. “If you decide that we are at maximum employment now and you intentionally slow down the economy, you will be leaving us behind, pulling up the ladder after you’ve climbed it.”
In my view, the Fed should ignore the unemployment rate, and focus on NGDP growth. But they’ve decided to base policy on inflation and unemployment, so let’s go with that assumption. In that case, they should focus on the overall unemployment rate, not the rate for particular groups. Monetary policy is not some sort of surgical instrument that can impact inequities between the unemployment rates of various groups.
Another argument is that the Fed’s inflation forecasts are non-credible, for various reasons. Inflation has only averaged 1.12% over the past 8 years, and TIPS spreads suggest lower than target inflation going forward. Those are good arguments, but in defense of the Fed it should be pointed out that the consensus private sector forecast calls for 2.1% inflation in 2017. That probably refers to the CPI, but even so it’s pretty consistent with the Fed’s 1.9% PCE forecast. So if the Fed is wrong, then so are private forecasters.
Another argument is that NGDP growth has recently been below 3%, and that’s the variable the Fed should be focusing on. I agree that the Fed should focus on NGDP, but they have decided not to do so. If you give the Fed advice based on NGDP growth, and they are targeting something else, you will merely destabilize the economy.
Here’s an example. Suppose you favor 4% NGDP growth. Also suppose that you advise the Fed to stimulate based on that policy target, and the Fed momentarily takes your advice. Now suppose that the Fed’s actual policy is 2% inflation, during a period when trend growth has slowed to 1.2%. In that case your advice will drive inflation up to 2.8%. The Fed will respond by tightening policy, and you’ll go into recession.
So then why (in the past) did I often advise the Fed to ease policy, while citing the low NGDP growth figures? Because during most of the period I’ve been blogging, policy was far too tight even using the Fed’s inflation/employment objectives. I mentioned NGDP because I thought that was a more useful indicator/target, and hoped the Fed would switch to NGDP targeting. But if they do not, then any short-term success in pressuring them to get NGDP growth up to 4% will be a Pyrrhic victory, merely leading to more macroeconomic instability down the road.
In my view the current Fed policy is very unwise. But not because the interest rate target is currently set in the wrong place, and not because policy is way too lose or way too tight. Rather I object to policy because the regime is too procyclical—leading to above target inflation during booms and below target inflation during recessions, when the reverse cyclicality is appropriate. And that problem is going to be there regardless of whether they raise rates in December, or not. “It’s the regime, stupid.” (Not you, of course)
If I were on the FOMC and had to vote on the assumption that the current policy regime stayed in place, I think I would vote against raising rates, due to TIPS spreads, but it would be a close call. If I got to choose my policy regime, I’d definitely vote against a rate increase, and try to nudge NGDP trend growth up to something more like 4%.
Of course in an ideal regime, neither my opinion nor Janet Yellen’s opinion would matter.