Minutes from the October meeting of the Federal Open Market Committee, made public last week, confirm the bullish tone struck by the shorter policy statement released earlier. While individual members see various risks, particularly from overseas, where the European and Asian economies appear to be weakening, as a group they acknowledged the considerable progress that the U.S. has made in recovering from the financial crisis and severe recession of 2007-2009 and the gathering momentum in various measures of aggregate activity that has appeared most recently. Against this backdrop, a broad-based majority agreed that it was fully appropriate for the Fed to finish winding down its massive bond-buying programs and to shift its attention to the issues of when and how quickly interest rates will have to rise beginning next year.
More good news can be found in the details of the report, which reveal a noteworthy decline in the extent to which Committee members are using the unemployment rate as their principal guide to how monetary policy is affecting the economy. A quick, mechanical search, for instance, turns up only three mentions of the world “slack” in the October minutes, versus nine in the record from the September meeting and eight in July.
This shift is most welcome. Both economic theory and history tell us that monetary policy can, and does, have important effects on unemployment. Indeed, Milton Friedman and Anna Schwartz’s famous study of the Great Depression shows how, by allowing the money supply to drop precipitously during the Depression, the Federal Reserve turned what would have been a more ordinary recession into the longest and most severe economic downturn our country has ever experienced. But Friedman and Schwartz were always quick to point out that while unemployment is surely influenced by monetary policy, the jobless rate is also buffeted about by an enormous number of other factors, mostly beyond the Fed’s control, making it difficult if not impossible to accurately gauge the amount of slack that is present in labor and product markets.
The Fed learned this lesson the hard way during the 1970s, when it made its worst mistakes since the Depression by overestimating the amount of slack in the economy and therefore adopting a monetary policy that was consistently too accommodative. As a result, during that era, Americans experienced the worst of both worlds: stagflation – the truly awful combination of high unemployment and high inflation.
Luckily, FOMC members appear to have remembered these important lessons in time to avoid a repeat of these past mistakes. In the United States today, the unemployment rate itself has fallen considerably as the economy has recovered, but labor force participation remains stubbornly low. Economists just don’t know enough yet about the basic factors driving these trends, making conventional measures of labor market slack unreliable as an indicator of whatever role monetary policy itself may be playing.
Instead, FOMC officials are asking themselves a different – and better – set of questions that focus more directly on the behavior of inflation, a variable that, unlike unemployment, monetary policy can effectively control. These questions include: Is the degree of current monetary accommodation, fueled by continued low interest rates but no longer by outright bond purchases, sufficient to bring inflation back to the Fed’s two percent target? And, if so, exactly when will interest rates have to rise in order to prevent inflation from eventually overshooting that target?
To help answer these questions, the graph below plots year-over-year growth in the Divisia M2 measure of the money supply. This graph suggests, firstly, that the Fed has not always been successful at stabilizing inflation in the U.S. in recent years. In retrospect, policy was too accommodative in the aftermath of the relatively mild 2001 recession, too restrictive in the years leading up to the financial crisis of 2007-08, and, somewhat tragically, withdrew much needed support for the struggling economic recovery in 2010, surely contributing to the sluggish price inflation that we’ve seen since then. For the past several years, however, broad measures of money have grown at consistently healthy rates and, given the lags with which these changes in money growth affect prices, this money growth should soon work to push inflation back to target.
The FOMC can now wait a little while, to make sure that the withdrawal of additional stimulus through large-scale asset purchases does not lead to a repeat of the sharp decline in money growth that we saw, previously, in 2010. But, so long current rates of 5 1/2 to 6 percent money growth continue, they will eventually lead to inflation rates that meet or exceed the Fed’s long-run target. To prevent such overshooting, the FOMC will probably have to start raising rates, as most of its members currently anticipate, sometime towards the middle of next year.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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