I enjoyed the chair’s speech today, assessing the state of the economy and holding forth on the Fed’s macro policy. Here are some bullets, along with an observation about an important way that life has gotten harder—maybe significantly harder—for the Fed in recent years.
–As is her wont, Yellen focused on the slack that remains in the job market. The number 6.5% as an unemployment benchmark was not in the speech. Clearly, and appropriately, the Fed no longer wants to signal that number as a meaningful threshold, focusing instead on “full employment” which for them is around 5.4%.
–In this regard, she referred to the gap between the current unemployment rate and this target as a significant shortfall, one that could take “…more than two years to close.”
–Let’s say that’s right, and I doubt it’s pessimistic. Let’s also stipulate, though I’ve got some issues with this assertion, that the unemployment rate was at full employment in 2007. That means a nine-year stretch—2007-2016—of slack job markets. And they accuse Japan having suffered through a lost decade.
–Numerous times in both her speech and Q&A, the chair noted low and decelerating inflation (core PCE) as a challenge. If I’m Yellen, I’m a little unsettled by such low inflation, even as there’s been some tightening and a bit of nominal wage growth (see figure three here). A key point she made is this, and it’s one I’ll return to in a moment: “…during the recovery, very high levels of slack have seemingly not generated strong downward pressure on inflation. We must therefore watch carefully to see whether diminishing slack is helping return inflation to our objective.”
–She again emphasized this critical point: “I believe that long-term unemployment might fall appreciably if economic conditions were stronger.” I think Yellen believes, as do I, that a stronger job market could not just lower long-term unemployment, suggesting a significant cyclical component remains in the jobless rate, but even more importantly, stronger growth could pull some folks who’ve left the labor force back in. I think of that as “reverse hysteresis” and it’s a very big deal regarding both living standards and macro growth.
So, what’s this troubling problem I referenced above? It is this: I think that while inflation has become less responsive to slack and thus to Fed actions that target slack, market reactions and even global capital flows have grown considerably more elastic to Fed moves.
It is pretty widely agreed that the Phillips curve has flattened in recent years, as I cover here. For full employment types, like Dean Baker and I, that’s good news in that you can worry less about price pressures as the jobless rate falls. For inflation hawks, on the other hand, it means the Fed could find it tougher than it thinks to slow faster price growth.
But at the same time, and here I’m admittedly in anecdotal mode, it seems like financial markets and capital flows are increasingly sensitive to the slightest unexpected Fed actions, even when those actions should really be expected, with last summer’s “taper-tantrum” being exhibit number one.
This raises the stakes for forward guidance/expectations management. Both Yellen and before her, Bernanke, were pretty clear that their main client is the real economy, which is as it should be. But if it’s true that financial markets have grown more sensitive to Fed moves than inflation, that poses a challenge the Fed can’t ignore.