Four lessons about contemporary monetary policy.

May 3rd, 2018 at 8:59 am

Yes, we live in chaotic, uncertain times, with nationalism, populism, and protectionism on the rise. Also, hush money to porn stars.

But amidst the noise, the Federal Reserve is quietly going about its business, hitting its dual mandate of full employment at stable prices. That is, the job market is close to full employment, with caveats, and inflation is at their 2% target, also with caveats.

Like almost every economist who’s not at the Fed (and some inside), I’ve got issues with some of their actions. But it’s worth pausing at the moment and recognizing that among our many failing institutions, like…um…I dunno…Congress?–the presidency?!–the Fed is one national institution that’s working well.

A key factor to their success is their political independence which insulates them, to a significant degree, from the dysfunction. And another factor that’s helped in this same regard is that the Trump administration’s appointees, especially Chair Powell, have been pretty solid. Thus far, the global economy has dodged a bullet.

Those caveats are non-trivial. Based on employment ratios–the employment/population rate of prime-age workers (EPOPs)–there’s more slack in the job market than the 4.1% unemployment rate suggests. We don’t know how much, but the persistent upward trend in prime-age EPOPs suggests that those who assumed they couldn’t climb back may have been too pessimistic.

This, in turn, raises the interesting possibility of “reverse hysteresis,” or: demand creates supply. Hot labor markets can pull in workers thought to be out of the game, and that creates more room-to-run. It also requires the Fed to be patient, and to recognize that supply constraints are yet another critical variable they can’t know for sure.

The other key caveat is around the inflation target. As the committee put it in their statement yesterday (my bold): “Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term.”

Fed watchers are trying to figure out if this means they’re seeking some sort of averaging out–inflation should be 2% on average over some undisclosed time period–or it just means they won’t freak out and slam the brakes if we get some price-growth readings north of 2.

I’d guess the latter, but the key point is that use of the word “symmetry” is important and means 2% isn’t a ceiling. Yesterday’s statement implied the important point that the board does not assume readings above 2% mean inflation expectations are de-anchored such that a price spiral is forthcoming.

So, here’s what I think this moment teaches us about contemporary monetary policy in advanced economies.

–It is critical to have a politically independent central bank. Any legislative actions to reduce that independence must be fiercely resisted.

–Because supply is a moving target that is to some degree responsive to demand, it is difficult to know the extent of supply constraints.

–Patience re rate hikes is thus a virtue which can, in and of itself, create more room to grow while allowing the benefits of full employment to reach those heretofore left behind.

–2% on inflation is a symmetric target; having been below it for years, we’ve earned the right to be above it for awhile without assuming expectations are no longer anchored on the target rate.

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One comment in reply to "Four lessons about contemporary monetary policy."

  1. dwb says:

    “Hot labor markets can pull in workers thought to be out of the game, and that creates more room-to-run.”

    –> and also, critically, productivity is historically pro-cyclical. Its less pro-cyclical than it used to be, but at the same time, since the 1980s, the Fed has been actively maintaining slack in the labor market to tamp down inflation. We don’t know what will happen if the labor market stays tight for an extended period. We should not assume productivity will remain low as the labor market tightens.