Monetary policy: Should the Fed target unemployment?
BEN BERNANKE’S speech today in Minnesota cut and pasted the key sentence out of his Jackson Hole remarks: “the Federal Reserve has a range of tools…[and is] prepared to employ these tools as appropriate.” What does this mean? I’ll trust Neil Irwin and Jon Hilsenrath: they say the Fed will ease in September.
If they’re right then maybe the rest of this blog post is moot. Nonetheless, it’s worth revisiting a meaty and intriguing speech that Charlie Evans, president of the Chicago Fed, delivered yesterday. Mr Evans has emerged as a vocal dove and counterpoint to the Fed’s hawkish contingent. The task facing those like Mr Evans who want the Fed to do more is how to justify it. The Federal Reserve Act requires that it aim for both full employment and stable prices. But in both theory and practice, the inflation part of this mandate trumps the employment part. The Fed kicked off QE2 last year when deflation threatened. It hasn’t yet given us QE3 because deflation isn’t knocking on the door.
Mr Evans provides a theoretical argument why more vigorous monetary ease aimed explicitly at lowering unemployment is justifiable right now. There’s a lot about this speech that I love, in particular this observation:
I do not think that a temporary period of inflation above 2% is something to regard with horror. I do not see our 2% goal as a cap on inflation. Rather, it is a goal for the average rate of inflation over some period of time. To average 2%, inflation could be above 2% in some periods and below 2% in others. If a 2% goal was meant to be a cap on inflation, then policy would result in inflation averaging below 2% over time. I do not think this would be a good implementation of a 2% goal.
This makes profound common sense. I would go even further than Mr Evans. The Fed should not just tolerate upside risks on inflation, it should consciously court such risks. If the Fed were to map today the range of inflation rates that might result from its monetary policy, the range should skew above rather than below its target because if it misses the target, it has more tools, experience and will to push inflation back down to target than it does to do the opposite. When you drive along a mountainside road, you should not equalise the risks of going off either side; better to risk scraping your fender on the side with the mountain than going into the canyon on the other.
Mr Evans continues, though. He argues that the Fed’s dual mandate can be interpreted in a way to require more forceful action on unemployment than it currently seems willing to tolerate. He starts with the basic notion that a central bank tries to maximise social welfare by minimising variations in both inflation and unemployment. If the Fed weighted both inflation and unemployment equally, it should clearly be easing more aggressively now because unemployment is so much further away from target (9% vs a natural rate of 6% or less) than is inflation. But as Kenneth Rogoff argued back in 1986, central banks achieve better results by assigning more weight to stabilising inflation than unemployment. Mr Evans uses some math to show that even with this higher standard, the Fed would still be justified, given current unemployment, to act more aggressively. He then goes on to say the Fed should commit to keeping policy easy until unemployment is below 7% so long as inflation doesn’t top 3%.
This is an intriguing argument but I don’t think it works. The Fed can influence the long-run level of inflation but not of unemployment. It can, however, affect the variation of unemployment: the better it is at controlling inflation, the less it has to hammer the economy, creating wasteful unemployment. Mr Rogoff argued that the public is more likely to take seriously a central bank that walks and talks like an inflation nutter. The result will be more stable price and wage setting, and thus the central bank will have an easier time maintaining low inflation without resort to punitive monetary tightening. Mr Evans’ solution would weaken the credibility of that commitment by appearing to condone inflation systematically above 2%. If inflation did top 2%, the central bank would eventually have to tighten again, raising unemployment. Mr Evans claims he’s not condoning a higher inflation target, but that is how such an announcement is likely to be interpreted. Thus, in pursuit of lower unemployment, the Fed risks creating more variation in unemployment in the future.
There are a lot of ideas floating around for operational frameworks that would better motivate the Fed to boost output and employment. Price-level targeting and nominal-GDP targeting are among these. The thinking is that when either falls below their long-run preferred path, the Fed would undertake more aggressive monetary easing to get them back. This would raise inflation but hopefully, also raise employment.
There are merits to these ideas but they seem to be weak substitutes for simply raising the inflation target. When nominal rates are stuck at zero, a higher inflation target makes real interest rates more deeply negative, which should boost demand and employment through the usual channels. However, raising the inflation target subtracts from the central bank credibility which could be costly to recover. Given the dire state of the world economy this may be a tradeoff worth making, but it must be dealt with, not brushed under the rug by adopting a new regime.
In truth, the Fed can do what Mr Evans suggests without resorting to numerical commitments or new regimes. Its mandate gives it all the authority it needs to ease monetary policy in pursuit of lower unemployment. Neither theory nor evidence suggests this must produce higher inflation. It does mean accepting a higher risk of inflation topping 2%—but as Mr Evans so valuably pointed out, that is fully consistent with a regime of targeting average inflation of 2%, which is already in place. All the Fed has to do is follow it.
The original article is linked here.