Dec 25, 2012 at 3:12 am
Just doing a bit more research on changing Fed policy and the tilt toward what you might think of as the Evans rule, i.e., applying a heavier weight to high unemployment when considering monetary policy. [In a speech last year, Fed governor Charles Evans said: “Imagine that inflation was running at 5 percent against our inflation objective of 2 percent. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.”]
Certainly personnel with such sensibilities are part of what’s going on, but there’s also the fact of the long growth slog with low, and in Fed-speak, well-anchored inflation (meaning people expect general inflation to stay low, even when there’s, e.g., a gas-price spike). Basically, they’ve got a dual mandate (low price growth and low unemployment) and one part of that is clearly not met, so targeting unemployment is their job right now. (It’s also a job they can’t do alone—low interest rates surely help, but demand-side fiscal policy—stimulus—is also necessary and very much MIA.)
One interesting way to see this graphically is to plot the Taylor rule (TR) against the Fed’s funds (FF) rate. The TR is an equation that sets the FF based on the relations between output and inflation; it specifies a lower path when output gaps are large and vice versa. The figure shows that in normal times over the last few decades, the TR and FF track each other closely, but in both the 1980s and now large gaps persist.
Those two periods were different in germane ways. Back in the early 1980s, inflation was unmoored–another oil shock–posting double digit growth rates. The Fed broke the inflation with crushingly high rates (that’s the conventional wisdom; increased oil production and energy efficiency in response to the price shock also helped) and was slow, relative to the TR, to take the FF back down. Now, of course, as can be seen in the figure, the FF is jammed by the fact that nominal rates can’t go below zero, even while the TR points there. Again, with quiescent price growth both observed and expected, this gap at the end of figure should lead a rational Fed to target the output gap, i.e., high unemployment.
In fact, and this creates a bit of a bias in the picture below, they have in effect closed part of that gap at the end of the figure with their QE initiatives (and the accompanying guidance). So, good for them for aggressively targeting the output gap, though to not do so would a) be a pretty explicit statement that they have but one mandate and b) suggest that they were not, as Gov. Evans suggested above, worth their salt.
It’s thus not at all weird that the Fed is aggressively targeting unemployment; what’s weird is that Congress is not.
Source: BEA, BLS, CBO, Federal Reserve, Yellin (2012)–see data note below for details.
Date Note: I used the Taylor Rule (1999) as described in footnote 15 in this 2012 paper by Fed governor Janet Yellin, with these differences: I used the CBO’s long-term NAIRU estimate series instead of a constant and I used an Okun coefficient of 2 instead of 2.3.
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