Two Papers That Could Persuade the Fed to Prolong Stimulus

Jan Hatzius, of Goldman Sachs, at the company's offices in New York in 2010 Photograph by Michael Falco/The New York Times via Redux

Staff members of the U.S. Federal Reserve don’t get to vote on monetary policy, but they can still be highly influential. Now two new research papers by high-ranking Fed staffers make the economic case for prolonging stimulus.

“It is hard to overstate the importance” of the two new studies, which will be presented at the annual research conference of the International Monetary Fund on Nov. 7-8, Jan Hatzius, chief economist of global investment research for Goldman Sachs, wrote in a note to clients today.

The key questions are how much unemployment has to fall and inflation to rise before the rate-setting Federal Open Market Committee decides to take its foot off the monetary gas. The Fed may taper its purchases of bonds in the next few months, but it has said it won’t start raising the federal funds rate—the short-term interest rate it controls—for much longer than that. Current policy—reiterated on Oct. 30—calls for the funds rate to stay near zero as long as the jobless rate stays above 6.5 percent; projected inflation between one and two years ahead is no higher than 2.5 percent; and “longer-term inflation expectations continue to be well anchored.”

One of the new Fed staff studies makes the case for lowering the Fed’s 6.5 percent unemployment threshold. It’s called The Federal Reserve’s Framework for Monetary Policy—Recent Changes and New Questions (PDF). It’s by William English, director of the Division of Monetary Affairs, along with David Lopez-Salido and Robert Tetlow. It says that according to the economic model they used, “reducing the unemployment threshold improves measured economic performance until the unemployment threshold reaches 5.5 percent.”

The second study for the IMF conference warns that high unemployment can become embedded in the economy through a process called “hysteresis.” To prevent that, the Federal Reserve would need to press hard for economic growth, even if it causes inflation to go above its 2 percent target for a certain period of time, say the authors, David Wilcox, director of the Division of Research and Statistics, along with David Reifschneider and William Wascher. The motivation for stimulus would be all the stronger, they write, if the Fed decided to focus more on the problem of people who have left the labor force entirely and are therefore no longer counted as unemployed. The motivation would be weaker, on the other hand, if policymakers worry a lot about creating bubbles or expectations of higher inflation. Their paper is called “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy” (PDF).

Taking these two papers into account, Goldman’s Hatzius says the firm now expects the Federal Open Market Committee to reduce its unemployment threshold to 6 percent, from 6.5 percent, at the March 2014 meeting (which would please monetary doves), while simultaneously beginning to taper bond purchases (which would please hawks.) Hatzius says both decisions could happen as early as this December.

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