New paper from our full employment project: Binder/Rodrigue on updating Fed toolbox

September 9th, 2016 at 8:11 am

Last week, the Center on Budget and Policy Priorities’ Full Employment Project published an important new paperMonetary Rules and Targets: Finding the Best Path to Full Employment—by Haverford’s Carola Binder and Alex Rodrigue (B&R).

The paper takes a close look at a critical aspect of how the Federal Reserve makes decisions about monetary policy: the rules and benchmarks that guide them in meeting their dual mandate of full employment and stable prices. B&R’s work is timely because the Fed’s old toolbox needs an update.

First, as B&R show, the Fed has been missing their 2 percent inflation target for about four years running. Importantly, this downside miss has persisted even as actual unemployment has fallen to match the Fed’s estimate of the “natural rate”—i.e., their estimate of the lowest unemployment rate consistent with stable inflation, which may well be too high.

Second, recent and new work by macroeconomists Larry Summers, John Williams, Olivier Blanchard, and others shows that interest rates across the globe appear to have undergone a structural downshift in recent years. Another key Fed parameter—their neutral interest rate target (the rate that is neither stimulative nor contractionary)—is also likely to decline. Both of these developments must ultimately be reflected in Fed policy.

Third, B&R point out that some outsiders are pushing the Fed to rely on some version of the “Taylor rule,” an equation derived by economist John Taylor that describes the Fed’s historical rate-setting behavior as a function of inflation and economic slack. But B&R argue that adherence to a rigid, simple equation would undermine the Fed’s discretion at crucial economic moments: “Following the Great Recession, for example, the original form of the Taylor rule would have directed the Fed to raise interest rates above zero in 2011, years before the labor market recovery was near completion, which would have slowed the recovery even further.”

So what tools should be in an updated Fed toolbox? B&R provide a useful table, shown below, which summarizes a set of monetary policy rules and targets along with the authors’ judgements as to which tools are best for hitting full employment. The two targeting rules they view as most promising in that regard are nominal GDP targeting and nominal wage targeting.

Under NGDP targeting, the Fed “would choose and announce either a target growth rate for NGDP or a target path for NGDP and adjust its policy rate to help achieve the target in the medium run; the bank would lower rates if NGDP were below target and raise them if NGDP were above target.” Since wages are the largest component of nominal GDP, targeting aggregate wages would resemble NGDP targeting, while wage targeting could alternatively focus on the growth rate of nominal wages (as B&R note, Josh Bivens has suggested 3.5 percent for an average nominal wage growth target).

Because nominal growth equals real growth plus inflation, both nominal wage and NGDP targets implicitly account for inflation while also focusing on indicators more likely to promote the goal of full employment. B&R observe that an NGDP target could have highlighted the need for more expansionary monetary policy between 2007 and 2009, potentially spurring policymakers to action sooner and easing the severity of the Great Recession.

Another useful tool reviewed by B&R, especially in the current environment, is price-level targeting. Under price-level targeting, the Fed targets a path for the price level over time. For example, they may decide it’s optimal for the economy if the price index is around 100 today, 103 next year and 106 the year after that. The useful attribute to level targeting is that if instead of hitting 103 next year, the price level is only 102, the public expects the Fed to employ stimulative monetary policy until inflation is back on its path.

How does that differ from current practices and what are its advantages? The Fed currently targets a 2 percent inflation rate, but it is ambiguous as to whether this is an average target (meaning that if you’re below it for a while you then need to be above it for a time) or a ceiling. If Fed officials view it as a ceiling, as their statements sometimes suggest, they’ll likely tighten monetary policy once they hit it even if they’ve been missing 2 percent for years and tightening means slowing job and wage growth that has eluded too many workers in recent recoveries. Under price-level targeting, there is no such ambiguity. If inflation is below the target path, the Fed tries to increase price growth, regardless of the percent change in prices.

We hope Fed officials and others concerned about the intersection between monetary policy and full employment carefully consider the typology offered in B&R’s paper. The authors have done some very useful work in illuminating the policy path toward full employment.


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6 comments in reply to "New paper from our full employment project: Binder/Rodrigue on updating Fed toolbox"

  1. Smith says:

    Uhmmm, I’ve been saying this for over a year, on this blog (quotes below). I don’t have time to provide the actual links this morning. It’s encouraging to see academics realize what’s going on. But how is this not also common sense?

    But the fallacy remains that to control prices one must use unemployment, implicitly slowing the economy to raise unemployment because businesses behave badly raising prices. Why is it when business controls prices, and raise them too much, workers must pay the price? There are other ways. The very definition of inflation is a price rise that has nothing to do with actual costs. How did we achieve low unemployment, rising wages, and low inflation before? Address how to curtail business from raising prices if you ever want to see full employment, rising wages, less inequality. Kennedy vs. US Steel is only one small example. What we really suffer from is epipenation inflation.

    “Every mention and implied support for the validity of the Phillips curve, NAIRU, or Taylor rule, only serves to propagate a basic misunderstanding of economics and common sense.”
    “Phillips curve, NAIRU, and Taylor rule mean the continued subjugation of labor, rising inequality, and slow growth with underutilization.”

    “Using slow economic growth, Philips Curve, NAIRU, the bludgeon of unemployment to curb inflation needs to be overthrown.”

    “Only when a political party or class sees the dominance of the 1% as a threat to their election or incumbency, will the Phillips Curve and NAIRU be consigned to the dustbin of history.”

    “The very vocabulary of Phillips Curve, NAIRU, and Taylor should be banished to the dustbin of history.”

    “The Taylor rule, NAIRU, and the Phillips curve, are ways to justify keeping unemployment at a high enough level to avoid wage pressure.
    Using the Taylor rule, NAIRU, and the Phillips curve, to create a reserve army of labor is not justified by economics.”

    “Any person giving any credence, any thought to Phillips curves and NAIRU says, look we have to endure pain and unemployment for the larger good.”

    “Dispense with NAIRU and Phillips curve crap and deal with business ability to always raise prices ahead of wages, antitrust, repeal of Taft Hartley, etc, and we’ll get somewhere”

    • Jared Bernstein says:


      All good points…

    • Smith says:

      Getting ahead of myself, some obvious errors in citing dates of my own previous posts.
      The dates of 9/15/16 and 9/28/16 listed above should been given as 8/29/16 (comment on an 8/29/16 post) and 8/28/16 (reply to a comment on the 8/24/16 post) respectively.

  2. Person says:

    OK, I’m just going to tell you this, think about it, don’t necessarily publish it.

    The aliens are here! They have technology that would blow your mind, but they respect our development.

    They can’t ship much here because of physics, so they only get their bodies here. They are here. They mean no harm. They’re more advanced than us, by just a few hundred years.

  3. Smith says:

    Someone on Krugman’s blog left this link:
    Stiglitz on the Fed Toolbox:
    “Central bank policies focusing on inflation have almost certainly been a further factor contributing to the growing inequality and the weakening of workers’ bargaining power. As soon as wages start to increase, and especially if they increase faster than the rate of inflation, central banks focusing on inflation raise interest rates. The result is a higher average level of unemployment and a downward ratcheting effect on wages: as the economy goes into recession, real wages often fall; and then monetary policy is designed to ensure that they don’t recover.”

    Yet when Stiglitz goes on to offer a program on restoring the economy, he completely neglects the question of inflation and the power of business over prices. If labor power was restored there would be a race to spiral prices ahead of wages. Indirectly, Stilglitz addresses by listing antitrust in his closing paragraph.
    The four measures he advocates are inadequate (executive compensation curbs, infrastructure, education, capital taxation). Instead of trying to curb executive compensation, just raise taxes to 1960 levels when effective rates at $10 million was 90% (marginal rates were 90% at $1 million). Very simple and proven to work (err, some work needed on distortions by tax 90% writeoffs). Infrastructure and education spending neglect the wage vs prices battle leading to inflation. It also ignores the glut of college educated workers. Spending on education must be accompanied by an even greater increase in government spending for all jobs requiring more education. Full employment does not work unless business is constrained not to raise prices. Finally, the capital tax at regular rates and accrual vs realization is very well short of point 1, 90% effective rates on income of $10 million.

    Anyway, Stiglitz ignores or neglects Fed policy and the power of business to control prices. He implies we just need to get the Fed to loosen up and inflation won’t get out of control, even if labor markets tighten. This is not necessarily true (don’t have time this second to get data for this). Other means of constraining prices must be derived. An side: Craziness kicks in when prices drop and then the following year rise. That year’s inflation looks high simply due to restoration of price levels.
    Also he ignores any solution to globalization depressing wages. The answer is simple. If workers don’t have rights in low wage countries, the U.S will not buy their products. Either global wages rise to the developed world’s or all wages eventually sink to the lowest. A house divided can not stand with two labor markets, one free, and one not. Brexit was just one response.

  4. Smith says:

    For completeness, here is Krugman in agreement referencing Tobin questioning the Phillips Curve