Overshoot 2% inflation.
It seems that the most recent employment report has convinced several* economists that there is a high risk that the Fed Open Market Committee (FOMC) will raise the target Federal Funds rate soon.
There will, predictably, be calls to respond to the good news by normalizing monetary policy, raising interest rates soon. And we will want to raise rates off zero at some point. But it’s important to say that (a) we are still highly uncertain about the underlying strength of the economy (b) the risks remain very asymmetric, with much more danger from tightening too soon than from tightening too late.
now is the time for the Federal Reserve to establish its credibility on the point that, if the economy enters a liquidity trap, the Fed is going to keep stimulating until the economy is out of the liquidity trap and interest rates can normalize. If the Fed does not do this now, future Fed Chairs will curse its name.
and G.I.
If unemployment does fall to 5% next year, that should have two beneficial effects for the labour market. First, it should push up wages. Hourly earnings rose 0.4% in November, an unexpectedly brisk and long overdue increase. But they are still up just 2.1% from a year earlier. Since profit margins are so wide, it will take several years of stronger wage growth to generate cost-push inflation. Second, some of the long-term unemployed who have quit the labour force should be drawn back in, reversing some of the loss of potential output brought about by the prolonged period the economy spent depressed.
To get inflation higher requires a negative output gap by allowing unemployment to fall below its natural rate for a time.
I’d just like to note that Krugman and DeLong complement each other as usual (and to compliment both as usualer). Brad notes a long term reputational advantage of inflation over 2% — I follow Brad who followed Woodward who followed Krugman in believing that, when the economy is in a liquidity trap, it is good for the monetary authority to credibly promise that it will allow inflation to rise above the normal target after the unemployment rate falls to the non accelerating inflation rate of unemployment (google “credibly promise to be irresponsible”). As Brad notes, a FOMC doing exactly that can only make it easier for future FOMCs to convince economic agents that it too will do exactly that.
Is this possible benefit which may or may not arrive in the distant future worth the costs of inflation slightly above 2% ? Of course it is. There is no jump in the marginal cost of a bit more inflation at 2%. 2% isn’t an especially important number**. If the 2% target was chosen rationally to maximize some reasonable social objective***, then a small benefit of higher inflation makes the optimal inflation rate higher.
The justification for choosing and inflation target, declaring it, and sticking to it is that it is possible for a clear simple rule which is followed mechanically to become credible. The risk that people will thing “the official target is 2% but next time we are in circumstances like these inflation will be allowed to get higher than 2%” is the reason to accept NAIRU unemployment when the unemployed wish they had jobs. In this case, it is a benefit.
It is possible to make an argument which isn’t internally logically inconsistent for raising the target Federal Funds rate — it is possible to make a logically consistent argument for anything if one is allowed to make any assumptions one pleases. But the argument actually made for higher rates soon is about as close as one can get to logical inconsistency if one is allowed to invoke confidence fairies, expected inflation imps and the whole pseudopsychological menagerie.
* Why did I link to Mark Thoma not to DeLong and whoever G.I. might be directly ? Well my original interest was in Mark Thoma and links not in policy and public welfare. I got to http://economistsview.typepad.com by clicking a link at www.sitemeter.com.
** I am referring to a vague memory (sorry no link) of Paul Krugman discussing US net capital income (GNP minus GDP) with Larry Summers in 1988 and saying “people who are smart enough to understand all that are smart enough to understand that zero isn’t an especially important number.” I thought that wasvery smart. I find it ironic that a few years later, he saw that the liquidity trap was baaack (pdf warning) and that, when it comes to nominal interest rates, zero is a particularly important number.
*** Note the if. I no more believe that the 2% target was chosen because it maximizes some social welfare function than I believe in unicorns.
Krugman neatly summarizes the difference between staunch keynesians and most everyone else: “the risks remain very asymmetric, with much more danger from tightening too soon than from tightening too late.”
Too soon? Aren’t we in the 6th year of the current expansion? Maybe we are in a new era where economic expansion will go on forever with never another bubble created, never again exceed carrying capacity, just a gentle sloping expansion ad infinitum -and maybe we are not.
DeLong speaks about credibility, but suppose the business cycle goes from trough to expansion and back to trough with QE and near zero fed funds rates throughout the cycle -what of the Fed’s credibility then?
Two things. First “credibility” means people believe that one says. In this context, it means people believe that when the FOMC says its future policy will be a given function of publicly observable variables, people believe that it will be. “Credibility” is not a synonym for “prestige” or “face” or “being the top dog” or “banana”. I am not suggesting that you have confused the concepts of “credibility” and “banana”.
Too soon means “sooner than we should”. You propose a rule based on years since the last trough. As far as I know, you are the only person who has ever suggested this. I assume you realize that some information relevent to the decision of when to raise interest rates has become available since June 2010, but your argument only makes sense if one assumes that none has.
Well part of the problem is a meta/linguistic one around the proper definition of “full employment” between labor and capital or at least finance capital.
For the working class generally “full employment” means that state where everyone willing and able to work can get a job at a living wage. For finance capital “full employment” is more readily identified with NAIRU, which in turn mostly seems to be that point at which there is still enough labor slack that workers can’t press for ‘real wages’, which are by definition ex inflation. In other words “full enough employment” and not “too full”.
But as it is we are trapped between two conceptual frames where on the one side ANY increase in ‘real wage’ is a sign that we have approached or overtaken NAIRU while the other side sees increases in ‘real wage’ as kind of the point of working hard.
It doesn’t help at all that the two sides have two very different conceptions of “living wage”, with the capital side seeming to equate that with something like “subsistence” (because people who have cell phones and refrigerators or for that matter inside plumbing cannot actually be “poor” {did the Sun King Louis XIV have ANY of that? NOOOH}). Meanwhile workers would rather see “living wage” be defined as having what in quainter times was called “The American Standard of Living” or “A chicken in every pot and a car in every garage”.
And all of this gets confounded by the historically insane idea that all wages are actually set by ‘marginal productivity’ and that any issues of whether that wage meets ANYONE’s definition of “living wage” or even “subsistence” not the responsibility of employers. Don’t like it? “Tell it to the Invisible Hand!!”
Given all this it is no wonder the Fed has so much difficulty fullfilling its dual mandate of low inflation and full employment, there is simply no way to target the latter in a way that would satisfy the purely contradictory desire of capital for no wage driven inflation and for labor of increased real wages. Arithmetically, if nothing else, those two concepts are in direct collision.
Perhaps this becomes more clear when we use Ed L’s preferred metric of ‘labor share’. Because any amount of increase in labor share is at least going to be perceived as a reduction in return on capital and from the latter’s perspective operationally the same as inflation.
Bruce:
“a meta/linguistic one around the proper definition of “full employment” between labor and capital or at least finance capital.” Is it possible for the economy to grow without an increase in labor employment?
“Tell it to the Invisible Hand!”
I wish I could credibly steal that.
“Is it possible for the economy to grow without an increase in labor employment?”
Of course. If you define ‘economy’ as ‘GDP’. Which most policy commenters do.
Now it MAY be impossible for the economy to grow without an increase in labor PRODUCTIVITY. But productivity can increase with decreases in labor employment. In fact much of management theory since Taylor has been about exactly that: more production with less labor hours.
Which is so obvious that it makes me think I am missing the point of Run’s question.
“MAY be impossible for the economy to grow without an increase in labor PRODUCTIVITY.”
I think I would challenge that too. I think we went through a phase where much of the growth did not involve Labor and just Capital appreciation.
If the Fed were following a price level path target, it would do this automatically. A period of below 2% inflation would be followed by an equal period where it targeted above 2% inflation. Which has an automatic stablisiser effect. Plus, it keeps the Fed honest and symmetric, because it must “pay for” its past mistakes.
NGDP level path targeting would be better still.
Nick that sounds right.
But it does imply symmetrical macro-effects from periods over and under the target. Which is not obvious nor particularly likely depending on where the target is set. For example suppose there is a real world Inf-Laffer Curve where the ideal and balanced target point is X and yet the Fed sets its official target as X-Y or X+Y. In either case the best results would occur when Y comes in smaller for longer periods of time for whatever reasons.
And since in this case the value of the target is tightly tied to NAIRU simply adopting a policy that sees optimal outcomes as equal times above and below the derived value of that target seems to wave the problem of proper targeting away.
This really isn’t Econ 101 or even Econ 1, it is more like Pre-Algebra. I don’t think we get too far with the starting point of “Assume Target = X”. Why assume 2% IS X?
Whch seems to be the ask behind Robert’s ***
“If the 2% target was chosen rationally to maximize some reasonable social objective*** ”
Yeah that is a big “If”. Whose objective? and Whose reason?
RW,
So if QE and near zero interest continue throughout the entire business cycle the public should pay no attention? The public shouldn’t even consider that the Fed might be looking at the wrong variables, might be fixating on a single variable, might be making the wrong decisions based on faulty assumptions, and might not know as much as they claim they know about fine tuning the economy?
This expansion will end at some point, what the Fed does will have much to do with its credibility. I think we at least agree on those counts.
However I do not agree that the Fed will gain credibility by demonstrating its intent to provide constant stimulation throughout the entire business cycle(s?) so long as the magical 2% inflation target is not met.
Mike:
What are you doing differently that I have to approve your posts? You are not new, that is for sure.
As an illustration I have advanced a policy advocacy position which in acronymic form is: MJ! ABW! And it is my belief that achieving MJABW starts accomplishing almost the whole of the agenda of the New Deal ‘Four Freedoms’. http://en.wikipedia.org/wiki/Four_Freedoms
Freedom of speech
Freedom of worship
Freedom from want
Freedom from fear
Because to me it is exactly the fear of want that enables the powerful to deny freedom of speech and worship to the weak. “No poor man ever gave me a job”. Alrighty then! So how do the poor attain Freedom?
MJ. ABW. More Jobs. At Better Wages.
But which almost by definition implies employment rates and real wage gains above NAIRU. I don’t see how you resolve that fundamental tension to serve the interests of both bankers/savers and workers. Or in other words the ‘dual mandate’.
Moderately overshooting a 2% inflation target is not catastrophic to the economy. I mean in terms of damaging the carrying capacity within productive capacity.
The concern is that inflation will overshoot too much like it did in the 1970’s. The excess inflation hurt long-run growth by inhibiting investment through greater uncertainty.
The only danger to the economy is if these current policies lead to an “excessive” overshoot of natural and sustainable levels.
Run75441,
You lost me there completely, my last post was address to RW – I was just too lazy to type out Robert Wal… ah, nevermind.