September 19, 2012 7:36 pm
Patience needed for Fed’s dual mandate
It has become commonplace in monetary policy discussions to say that the US Federal Reserve is “missing on both sides of its dual mandate”. This is often taken to imply that Fed policy is far from ideal. Such an inference does not necessarily follow; using levels of inflation and unemployment to assess current policy is imprecise. It says little or nothing about the appropriateness of the Fed’s actions.
The Fed has a directive that calls for it to maintain stable prices as well as maximum employment, along with moderate long-term interest rates. Since unemployment is high by historical standards (8.1 per cent), observers argue the Fed must not be “maximising employment”. Inflation, as measured by the personal consumption expenditures deflator price index, has increased to about 1.3 per cent in the year to July. The Fed’s target is 2 per cent, so critics can say the Fed has not met this part of the mandate. When unemployment is above the natural rate, they say, inflation should be above the inflation target, not below.
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I disagree. So does the economic literature. Here is my account of where we are: the US economy was hit by a large shock in 2008 and 2009. This lowered output and employment far below historical trend levels while reducing inflation substantially below 2 per cent. The question is: how do we expect these variables to return to their long-run or targeted values under monetary policy? That is, should the adjustment path be relatively smooth, or should we expect some overshooting?
Evidence, for example a 2007 paper by Frank Smets and Raf Wouters, suggests that it is reasonable to believe that output, employment and inflation will return to their long-run or targeted values slowly and steadily. In the jargon, we refer to this type of convergence as “monotonic”: a shock knocks the variables off their long-run values but they gradually return, without overshooting on the other side. Wild dynamics would be disconcerting.
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Given this type of adjustment, it is clear the Fed could be “missing on both sides of its mandate” during the entire time it takes the economy to return to normal, even when the monetary policy is sound. In fact, missing on both sides of the mandate is exactly what one would expect under an appropriate monetary policy. Furthermore, the literature suggests that the adjustment times are quite long, possibly many years.
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To argue against monotonic convergence now would imply that when unemployment is above the natural rate, monetary policy should aim for inflation above the Fed’s 2 per cent target. On the face of it, this does not make sense: the US has experienced periods when both inflation and unemployment have been above desirable levels. In the 1970s this phenomenon was labelled stagflation. Monetary policy has been regarded as poor during that period.
Some may argue that real output and employment in the US have not returned to the pre-crisis, bubble-induced path that seemed to prevail in the mid-2000s. Indeed, US employment is about 4.7m lower than at its peak in January 2008.
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But this is to be expected. Recoveries in the aftermath of financial crises tend to be especially protracted, as the work of Carmen Reinhart and Kenneth Rogoff has documented.
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The financial crisis and the housing collapse probably did some permanent damage. The US growth rate is probably at about the potential growth rate given the situation, not far below as critics have suggested.
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There are, of course, important caveats to this argument. In reality, unlike the academic models, other shocks occur during the long adjustment process that make it hard to know which adjustments are actually occurring. US monetary policy also has unconventional features, such as quantitative easing. But still, the best models we have suggest that unemployment and inflation adjust in a monotonic
way to demand shocks under a high-quality monetary policy.
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This indicates that current monetary policy in the US remains broadly appropriate: it has produced the basic pattern of adjustment that we should expect based on available research. The Fed’s recent adoption of a flexible form of quantitative easing should enable it to continue to pursue this approach through management of its balance sheet as new economic information arrives.
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The writer is the president and chief executive officer at the Federal Reserve Bank of St Louis
Copyright The Financial Times Limited 2012.
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