U.S. Economy Slack Justifies Stimulus, Top Fed Staff Papers Show
The Federal Reserve’s policy of seeking to drive down the U.S. unemployment rate is effective, and the level of slack in the economy justifies an accommodative stance, according to two separate papers by top Fed officials.
William English, head of the Division of Monetary Affairs, wrote that the strategy of not raising interest rates if unemployment is above 6.5 percent has provided effective stimulus, and that an even lower threshold could be helpful. A paper by David Wilcox, the research and statistics chief, says that slack in the economy argues for loose policy at a time of contained expectations for inflation.
With the central bank debating the timing of winding down its $85 billion a month in bond purchases, the research provides a window into the views of the senior Fed staff members who write the briefing materials for Federal Open Market Committee meetings and draft the Fed’s policy options. The papers were posted on the International Monetary Fund’s website ahead of a two-day conference starting tomorrow in Washington.
“Our initial assessment is that they considerably increase the probability that the FOMC will reduce its 6.5 percent unemployment threshold for the first hike in the federal funds rate,” Jan Hatzius, chief economist of Goldman Sachs Group Inc., wrote in a note to clients yesterday, referring to the two studies. Such a move would happen before or “coincident” with the first tapering of quantitative easing, Hatzius said.
English and his co-authors present a simulation showing that lowering the unemployment threshold to 5.5 percent “improves measured economic performance” in their model. The jobless rate has remained above 7 percent for almost five years.
At the same time, lowering the level even further, to 5 percent “reduces welfare, as the control of inflation becomes notably less precise,” according to the paper.
“Our examination of the possible benefits of employing threshold-based forward guidance suggests that thresholds, if understood and seen as credible, can significantly improve economic outcomes,” according to the paper by English and Fed co-authors J. David López-Salido and Robert Tetlow.
Wilcox’s paper, to be presented tomorrow followed by English’s on Nov. 8, says that the “level of economic slack has been and remains quite high.”
“As has been noted by a number of observers, this factor by itself would argue for a highly accommodative monetary policy, particularly in an environment of what appears to be quite well-anchored inflation expectations,” Wilcox and Fed co-authors Dave Reifschneider and William Wascher wrote.
The IMF’s conference, with the theme “Crises: Yesterday and Today,” concludes with a panel discussion featuring Fed Chairman Ben S. Bernanke, former Bank of Israel Governor Stanley Fischer and Lawrence Summers, ex-top economic adviser to President Barack Obama.
Joseph LaVorgna, chief U.S. economist for Deutsche Bank Securities Inc., said the Fed research could be used to justify strengthening the central bank’s commitment to low interest rates even while beginning to slow the pace of asset purchases.
Under such a strategy the central bank could reduce its $85 billion a month of bond buying, and soften the blow to financial markets by pledging to hold the target interest rate near zero until unemployment falls to 6 percent. That would be a longer period of low interest rates than the current pledge to hold until unemployment reaches 6.5 percent.
“By lowering the unemployment-rate threshold, the Fed is essentially adding accommodation through forward guidance by signaling that rates will stay lower for longer,” LaVorgna said yesterday in a note to clients. “In doing so, policy makers can effectively counteract tightening of financial conditions caused by tapering asset purchases.”
“Therefore, all else being equal, a reduction in the unemployment rate threshold would enable policy makers to taper sooner due to the offsetting effects of extended interest-rate guidance,” LaVorgna said.
Both Fed papers include caveats. Wilcox said the economy has suffered structural damage that cannot be simply offset by Fed stimulus. “In the labor market, matching efficiency seems to have been somewhat impaired, the natural rate of unemployment appears to have risen somewhat, and trend labor force participation appears to have moved noticeably lower relative to what would have been expected based on pre-crisis trends.”
English said the Fed should be cautious in considering whether to raise its goal for inflation above the current 2 percent, or in pursuing a target for growth in nominal gross domestic product. Though the ideas may work well in economic models, they rely on assumptions that may not be realistic if actually implemented, he wrote.
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