Some thoughts on that new Fed paper everybody’s talking about.

September 2nd, 2018 at 11:38 am

It’s a lovely morning on the back porch, and the mind turns to that new Fed study everybody’s talking about. It’s the one by Erceg et al about monetary policy at moments like this one, with a flat Phillips Curve (PC), u<u*, along with much uncertainty about u* (importantly, I’d argue that uncertainty is asymmetric; the Fed’s estimate of u* looks too high). BTW, ‘u’ is the unemployment rate; ‘u*’ is the estimate of the “natural rate,” the lowest rate associated with stable prices.

I’ve got a longer, less cryptic piece on this study coming out later this week in WaPo (tomorrow, it’s Dean Baker and I celebrating Labor Day with a piece on unions as a potent weapon against inequality). But I wanted to set the table for that piece with a bit of analysis here. The WaPo piece explains any oblique terminology; apologies in advance for any obscurities in what follows.

One reason this piece, which I found to be a thoughtful/useful bit of work, is getting a lot of attention is because its key finding is counterintuitive. Given that unemployment has been well below the Fed’s estimate of u* of 4.5% and inflation’s (PCE core) just now hitting their 2% target, many of us have argued that the optimal monetary policy is to downweight the unemployment gap and focus on the lack of wage or price inflation.

Consider, e.g., the strong version of this view from EPI’s Josh Bivens: “…the definition of labor market slack is wage growth too weak to put upward pressure on the Fed’s price inflation target. If this wage growth is not happening, there is labor market slack. So, simply looking at some quantity-side measure of the labor market (say the unemployment rate) and thinking ‘hmm, that’s low, we must be at full employment” is substituting gut feeling for economic reasoning.’”

In a similar vein, Baker and I have argued that you know you’re at full employment when extra demand generates not jobs and real wages, but inflation.

But the Fed study comes to a different conclusion, arguing that even if u* is uncertain, it’s “better” to target the employment than the inflation gap. The definition of “better” is key, of course, and the authors are explicit that their definition bakes in their result in ways with which reasonable critics may disagree (more on that in a moment).

The paper does a bunch of macrosimulations of unemployment and inflation outcomes using a set of monetary rules that apply stronger or weaker weights to the employment and inflation gaps. The find that “because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.”

This is interesting. While camp Bivens sees the combination of the flat PC and overestimated u* as a reason for accommodative monetary policy, their simulations suggest that because of the flat PC, over-weighting the inflation gap will lead to wide and damaging (to demand) swings in monetary policy.

In fact, conditions in the current economy partially drive their result. Suppose the Fed listens to Bivens et al and targets inflation instead of unemployment. Because inflation has long undershot the Fed’s 2% target and the PC is so flat, it would take historically very low unemployment to juice inflation. Conversely, suppose some shock to the system…like, um, a trade war…led inflation to spike; then, the authors argue, it would take really high unemployment to bring inflation back down.

The study’s simulations thus find that if the Fed weighted up its inflation target relative to its unemployment target, the jobless rate could fall so low or climb so high that it could generate “risks to financial stability and more generally to the sustainability of macroeconomic outcomes.”

One way they end up there is by scoring success through a “loss function” that penalizes policy makers for letting the jobless rate fall below u*. But with u* higher than it should be, this approach doles out undeserved penalties for running a hot labor market (when they plug in a u* of 3.7%, upweighting the employment gap looks less favorable; compare Table 3, column F, rows 3 and 6). Their symmetric loss function (being below u* is as bad as being above it) also discounts the extremely valuable benefits of super-tight labor markets to less advantaged workers, a benefit that is especially worth tapping right now given the lack of price pressures. I’d want a loss function to reflect these benefits, one that treats being below u* as preferable to being above it.

As noted, the authors are explicit about this point, and the loss function they use is standard fare. Still, the paper is replete with so many variants, why not add one more? I urge the authors to run the results through a loss function that meets the criteria just noted.

I’ve got two more objections to the findings.

First, at least as I read it, the paper seems to suggest the Fed is unable to look past inflation perturbations caused by supply shocks. As just noted, the simulations appear to combine this inability with the flat PC to generate sharp, yet unnecessary (because it’s a temporary shock, not a shift in demand), accommodation or tightening. But this seems demonstrably wrong, as just recently, Fed statements have included many references to temporary shocks to prices, including energy, cell phone pricing, and Trump’s trade mishegos (the latter of which could eventually whack demand).

Also, what about all those years of hard work by Fed officials to anchor expectations? That too leads people to look through temporary shocks and assume stable, long-term prices. (See the bottom panel of their Figure 1 for evidence of well-anchored inflation expectations.)

Second, in numerous places, including the quote above, the paper argues that it’s better to be a bit more hawkish to avoid financial instability. This seems like step backwards. Former Chair Yellen and others have been very clear on this point: when we use tighter monetary policy to regulate bubbles in financial markets, we penalize the great many to hold back the reckless few. It is macroprudential policy and Dodd-Frank style regulation that should be the first line of defense against excesses in financial markets.

I get that Powell recently (wisely) argued that, given their far-reaching potential damage, the Fed should put financial excesses high on its watch list. But, if the real economy is not overheating, that doesn’t imply that fighting them with higher rates is preferable to regulation, “irrational-exuberance”-style forward guidance, and higher capital buffers.

That said, I strongly recommend the paper to those of us calling for heavier relative targeting of inflation as opposed to employment. It offers some high-calorie food for thought.

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10 comments in reply to "Some thoughts on that new Fed paper everybody’s talking about."

  1. Per Kurowski says:

    Current risk weighted capital requirements for banks, higher for what’s perceived as risky, lower for what’s perceived as safe, would you qualify these as intuitive or counterintuitive?

  2. Manqueman says:

    FWIW: I’ve been pondering the idea that the drop in the unemployment rate is due to what maybe one can call statistical unreliability. At the moment, whatever calculus is being used to determine the number is way too removed from the reality of the post-2008, deflationary job market. As always, the standard for accounting for those no longer looking desperately needs addressing. And unlike prior recoveries where jobs were replaced with jobs, this time is jobs replaced by gigs — temp, part-time, freelance. Given the degrading of employment, a flawed unemployment number is a problem, except, of course, for the corporate media for whom the number iseverything, and the BS behind it of no importance.

    • Bert Schlitz says:

      That is irrelevant. It is all the Boomers and disability. Everything you said there, is accounted for. Temp,part timers,freelance. The BLS handles that.

      It is the fact many Boomers checked out quickly after the last recession, went on disability(when they shouldn’t have been allowed) yet continued looking for work, which should put them on the LFPR. Since they are on disability, they don’t get counted.

      My point? If they decide to take a job, they go off disability. It is like a trickle, here and there. It is keeping wage pressures down as they add extra bodies for the employer to tap into. Generation Jones definitely has taken advantage of the system. We had this in 1999 as well, but the workforce was only at the very beginning of the “greying” and the fraud had much less impact on the U-series.

  3. Rima Regas says:

    “In arguing for a risk management approach, Mr. Powell invoked a principle attributed to the economist William Brainard, saying, “When you are uncertain about the effects of your actions, you should move conservatively,” much like starting a patient on a small dose of medicine to judge the reaction.”


    “Mr. Powell turned to a nautical pun to explain the challenges of setting monetary policy. When economists refer to the natural rate of unemployment, they use the term “u*,” pronounced U-star, and call the natural interest rate r*, or R-star.

    But these natural rates are the Fed’s best estimates, and must be inferred from things that the Fed can measure more directly, like wage growth and inflation.

    “Navigating by the stars can sound straightforward,” Mr. Powell said. “Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly.””

    Let’s hope whatever Trump throws at him, he remembers these quotes…

  4. Robert Salzberg says:

    The trucking industry is exhibit A that a tight labor market doesn’t create wage pressures when Labor power is extremely weak compared with corporate power. I work in health care where there has been a generations long shortage in areas like nursing without wage acceleration. The opposite is true at the top. CEO salaries are grossly inflated in America with what companies could pay to get good help.

    The last big spike in inflation in America was mostly due to a spike in oil prices. Prices of energy and basic materials are much more closely linked with general inflation than labor market conditions.

    Also, the Fed raising the overnight lending rate has a direct effect on inflation.

    The real question is why leading economists haven’t changed their models to better reflect economic reality.

  5. Bert Schlitz says:

    Add back in the excess number of Boomer’s committing disability fraud, unemployment should be higher. This is a problem that the BLS could fix by going back to 1948 and adding all people on disability to the LFPR. Do that and you will find out unemployment is more like 5.4% not, 3.9%.

  6. Benjamin Cole says:

    “They find that ‘because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.'”–Bernstein quoting the Fed article.

    Whatever else one says about the Fed paper, this strikes me as boogeyman fear-mongering.

    And gadzooks!

    Given what happened in 2008, isn’t a much-more compelling boogeyman something like, “because monetary policy acts with a lag, jumping too soon to fight inflation, particularly when economic conditions are such that outsized deviations of a normal GDP growth paths are plausible, risks destabilizing financial markets and provoking a deep recession.”

    BTW, the best economic boogeyman fear-mongering uses expressions like, “unforeseeable but catastrophic financial instability.” Add on the word “unforeseeable” when lecturing about the ill-effects of a policy you oppose.

    Bottom line: The Fed is an independent public agency, staffed by people in sinecures. They never have to be right, and never face consequences. The free-market never wipes them off the map. The Fed is not even sunsetted every 20 years for a updated approach.

    The Fed does seek to protect its reputation and has hired platoons of economists to do so,

  7. tom michl says:

    Jared, your proposal to put more weight on the output gap is misplaced. What we need is an explicit output (or employment rate) target in the loss function. Hysteresis can work in reverse. Here’s how it could work:

    also see:

    • Jared Bernstein says:

      The links don’t work! FTR, my post was critiquing, not endorsing, the upweighting of the output gap relative to inflation given current conditions. And I’m certainly open to a loss function that rewards very tight labor markets.

  8. tom michl says:

    Sorry, Jared. I got it backwards. I’m all for putting more weight on the inflation gap but that is not enough, IMHO.

    Here are some better links I hope.

    (I posted a similar reply and it did not seem to go up, so apologies if this is redundant.)