How should we evaluate policy?
By Scott Sumner
Here’s Tyler Cowen:
The Fed thus could make an error on either side of its target, through no procedural fault of its own. As a result, as a simple matter of logic, the rate of price inflation could be too high, or it also could be too low.
if you think you know the direction of the error in advance, you aren’t paying enough attention to the underlying unpredictable uncertainties.
If by “know” Tyler means, “know with certainty” then he is correct. But while we may not know with certainty (or even a high level of confidence) what will happen in the future, it’s possible to know with a high level of confidence what is currently expected to happen. There are many ways to ascertain inflation expectations, and all of the methods that I am aware of point to expectations of unusually low inflation going forward.
TIPS spreads, fed funds futures prices, recent CPI readings, commodity prices, wage cuts, and private sector forecasts all point to lower inflation going forward. None of those are foolproof, but where is the evidence of higher than normal inflation expectations?
If we assume that policy should be set in a position where it is expected to lead to on-target outcomes, then we can be highly confident that the current stance of monetary policy is too tight, probably much too tight.
Let’s say the Fed does the very best job possible with its monetary policy (and in my view the Fed has done a very good job so far). That would mean in terms of the loss function a Fed error in one direction would mean a too low rate of price inflation, and a Fed error in the other direction would mean a too high rate of price inflation.
Now, supply conditions have never been so volatile in my lifetime, and perhaps never in American history. We don’t know how the virus will spread, how reopenings will go, when a vaccine will arrive, how good the vaccine will be, how much a climate of fear will persist, and so on. Demand conditions in turn depend on how these supply conditions will evolve.
I would say that when the Fed is doing a “very good job” then demand conditions do not depend on supply conditions. At least not over the medium term (say in 2021.) If the economy is still in lockdown in 2021 then you can argue that it’s appropriate to let demand conditions be partly determined by supply conditions. I don’t expect the economy to be in lockdown in 2021. And “moderate social distancing” is not a sufficient excuse.
One final point. Don’t confuse “doing better than the ECB and BOJ” with doing a good job. Don’t confuse “doing better than the Fed would have done in earlier decades” with doing a good job. Don’t confuse taking unprecedented steps with doing a good job. Don’t confuse being the best Fed chair in Fed history with doing a good job. Doing a good job means setting policy at a level expected to lead to on-target outcomes for the nominal aggregates that you are targeting. Lars Svensson’s “targeting the forecast” is the only valid criterion for evaluating Fed policy.
If the Fed can’t do a good job for political reasons, then say so. Say the Fed can’t do a good job for political reasons, and point fingers at who is stopping the Fed. But we shouldn’t call it a good job if political constraints are forcing a sub-optimal policy.
The Fed is not to blame for the current elevated rate of unemployment. But the Fed likely will be partly to blame for high unemployment much sooner than most economists recognize. Perhaps even by later in the year.
PS. When I say that inflation is likely to run below 2%, I mean in terms of a price level trend line from the end of 2019. In other words, the average inflation rate. I certainly recognize that there will be a few months of above 2% inflation when oil prices bounce back up.