The FOMC statement and press conference on March 19 mark the beginning of the Yellen era at the Fed. Much of the current chatter has centered on the Fed’s communication
, but a tension in its monetary policy strategy poses greater risks.
The Federal Reserve’s statutory mandate directs the Fed to simultaneously promote two incongruent objectives: price stability and maximum employment. While delivering price stability is an appropriate goal and within the control of the central bank, maximum employment is neither.
A central bank can best contribute to promoting maximum employment over time only indirectly, by safeguarding price stability and financial stability in the economy. Real economic variables, such as the level of output or the rate of unemployment that is attainable over time, are determined by nonmonetary factors and other policies, for instance policies that promote technological innovation and improvements in the functioning of labor markets. Changes in employment also reflect unintended consequences of other policies, for example on healthcare, as highlighted recently by the Congressional Budget Office. To be sure, these nonmonetary factors bring about the economy’s longer-run normal unemployment rate that is consistent with price stability. But the Fed has no way of knowing what the normal rate will turn out to be when setting policy.
Over its history, the Fed oscillated between two very different approaches. One approach has been to prioritize monetary policy first and foremost to deliver price stability in the medium run. This is the approach followed during the Volcker-Greenspan era prevailing in the 1980s and 1990s. This approach recognizes that when price stability prevails over time, the economy also naturally attains full employment. It properly acknowledges that the Fed cannot know what full employment is when setting policy, and it avoids overpromising on things it cannot deliver.
The alternative approach has been to focus instead on employment and fine-tune the economy’s performance around a full employment target. Sophisticated models can be brought to bear to define a target for unemployment that is thought to be consistent with price stability. In theory, the Fed can rely on that target for policy guidance. If unemployment is above the target, policy is deliberately kept accommodative. Correspondingly, inflation becomes a lesser concern and steeply de-prioritized. Indeed when unemployment is perceived as unsatisfactorily high, fine-tuning proponents seek to deliberately raise inflation above the Fed’s price stability objective in the hope of attaining the normal unemployment target faster.
Historically, this latter approach has been a recipe for disaster. Indeed, it is a page from the playbook of former Fed Chairman Arthur Burns, unwitting enabler of the U.S. inflation of the 1970s. The reason is simple and well-documented. When the sophisticated analysis by the Fed correctly measures the unemployment target that is consistent with price stability, all is well. Policy is moved to aggressively hit the correct employment target and price stability prevails.
Problems arise when the sophisticated analysis misses the mark, which is par for the course in economic forecasting. What happens when the Fed targets an overly-optimistic unemployment rate? Then, despite good intentions, this approach eventually leads to high inflation and worse economic outcomes, as experienced in the 1970s.
This fine tuning Kabuki could be avoided with a better formulation of the Fed’s mandate. Congress could clarify that price stability is the Fed’s primary goal. With its current mandate, the Fed faces a choice critical for determining whether the next decade is more likely to mirror the 1970s or the 1990s.
The Bernanke era saw an important advance in the Fed’s communication strategy: A two percent inflation target was adopted as the Fed’s definition of price stability. If respected as a primary goal, this welcome clarification can safeguard better policy outcomes. However, the FOMC also started providing participants’ assessments of the long-run normal rate of unemployment, as a guide for maximum employment. The central tendency of FOMC participants’ most recent assessments is 5.2 to 5.8 percent, suggesting a midpoint 5.5 percent unemployment rate as a policy goal. Furthermore, since December 2012, the unemployment rate has become a primary guide for communicating and setting policy. The Fed effectively promised to keep the policy rate at its zero floor at least as long as the unemployment rate had not crossed a 6.5 percent threshold.
Has fine-tuning returned to the Fed? The disappointing pace of recovery from the crisis has created a public outcry and tremendous political pressures to improve employment prospects. The Fed has responded by elevating the role of the unemployment rate in its policy communication. But it is unclear to what extent the pendulum has swung towards the fine-tuning approach. Take the unprecedented accommodation of recent years. With inflation below the Fed’s definition of price stability, policy easing could have been justified as needed to attain the Fed’s inflation goal. Even though it was unnecessary, the Committee opted to elevate the role of the unemployment rate in its communication.
This fine-tuning concern did not matter in 2012 when the unemployment was far above conventional notions of normalcy. Perhaps at that time it merely served as a consensus building device. This year and beyond, with the unemployment rate substantially reduced, the issue becomes critical. Concerns about a fine-tuning Fed should elevate the scrutiny placed on the Committee’s assessments of what is normal unemployment. Indeed, a striking disconnect appears to have evolved in this regard vis-à-vis other assessments. For example, in the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, the median response in the latest pertinent survey identified six percent as the natural rate of unemployment, a number well outside the central tendency of the FOMC. Such discrepancies highlight the inflationary risk inherent in the fine-tuning approach.
The actions and communication of the Fed during 2014 will clarify whether a fine-tuning mentality has returned at the Fed. The FOMC may justify the fine-tuning approach by pointing to its statutory mandate to promote maximum employment. Alternatively, the FOMC may reassert the primacy of price stability as the path to maximum employment. The choice is stark: The fine tuning of the 1970s or the goldilocks years of the 1990s? With the proper strategy, the Yellen era could usher in the next fabulous decade.
Gregory D. Hess is President of Wabash College and a member of the Shadow Open Market Commitee. Athanasios Orphanides is Professor of the Practice of Global Economics and Management at the MIT Sloan School of Management. Both are former members of the Federal Reserve staff.
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