John Williams who is the president and chief executive officer of the Federal Reserve Bank of San Francisco published a letter yesterday explaining unconventional monetary policies. First I want to appreciate the clarity and simplicity with which John Williams is able to communicate complex ideas. His voice is honest, transparent and credible.
What did he say? Primarily he said that unconventional monetary policy has been moderately effective and has its limitations. For example, the forward-guidance communication of the Fed has had problems by affecting outside bond rates. He acknowledges an error by the Fed. But at the same time, the Fed has been able to clarify the long-term outlook of the economy, which has helped business plan appropriately.
Yet, his communication itself has a limitation. There is no way possible that he could project a recession. Even if he saw the possibility of a recession, he would not be able to mention it. How could forward guidance include a projection of a recession? The mere mention of a projected recession would create uncertainty that would undermine the markets.
Let’s face it, recessions are part of the business cycle. Yet, I do not detect the slightest hint of a future recession in his words. Thus there is a large hole in his words. Wouldn’t it be better to acknowledge a future recession and then communicate a corresponding plan to ameliorate it? That would be a very honest and important issue to clarify. Nevertheless, he cannot go there.
We need to realize that it is not easy to determine when a recession will start. The psychological factors themselves can hasten or delay a recession. The Fed has uncertainty about a future recession. John Williams who I respect tremendously projects an unemployment rate of 6.5% in early 2015 and that by the end of 2015, the Fed funds rate can start rising off of its zero lower bound. He views the natural rate of unemployment at 5.5%. He views the Fed funds rate rising through 2016 toward 2% by the end of 2016. Thus, he projects the economy getting back to normal by the end of 2016. Beyond that point, it seems implied that a recession is not a concern because the economy would be back to normal.
Yet, his letter uses the words “new normal” in the title. He uses those words in reference to unconventional monetary policy. I will not read too much into that, but only to say that the economy itself may be in a new normal. He does not view the economy in a new normal, which would mean a much higher natural rate of unemployment. Yet, somewhere in his mind must exist the question whether the economy really has shifted to a new normal. On the outside, he disregards a new normal. But when Ben Bernanke asks at the start of meetings whether QE is working or not, the possibility of a new normal must be addressed. My sense is that the meetings end up disregarding a new normal that would mean a higher natural rate of unemployment.
My research into effective demand shows a new higher natural rate of unemployment between 6.5% and 7.1%. My research is untested in real time because it is new. A higher natural rate of unemployment would mean that a recession is much closer than 2016. If my research turns out to be true, it would be a breakthrough in understanding recessions and the problems that are creating the current high unemployment.
To wrap up…
John Williams has a traditional and safe view of the future of the economy. Basically, he states that things will slowly get back to normal. Unconventional monetary policy will go away and only come back if things get rough again. His words induce certainty that the economy will be alright.
But I am not buying it. He is leaving out some crucial factors. He never mentions the fall in labor’s share of income. He doesn’t offer an explanation for such low inflation and the steeply rising asset prices. He doesn’t even offer an explanation for the high unemployment. And yet he must know that the economy is demand constrained in the aggregate. He offers no explanations for these factors and only concludes that the economy is slowly getting back to normal.
He seems to disregard that income inequality and a low labor share of income will have any effect. The economy will simply get back to normal, and yet its basic structure for distributing money has moved to a place far from normal.
If there were an aggregate demand constraint that leads to ongoing low inflation and high unemployment beyond 2015, there is nothing in his words addressing it. That worries me…