The Fed Knows How to Hit Its Target
My former Federal Reserve colleague Kevin Warsh has penned an article in the Wall Street Journal that assails the central bank for its "deeply flawed" management of the economy. I disagree with many elements of his argument, but I want to focus on one: that the Fed doesn’t know how to achieve its inflation objective.
Warsh suggests that the below-target inflation of the past several years has come as a surprise to the Fed -- a belief that, judging from comments I have received by email and on Twitter, many people share. Yet as he should know from his five years as a Fed governor, this impression is completely false. The evolution of both consumer prices and unemployment over the past five years is entirely consistent with what the central bank's staff predicted, and (more arguably) consistent with what officials intended.
Consider the November 2010 meeting of the policy-making Federal Open Markets Committee, where officials (with guarded support from both Warsh and me) initiated a second round of bond-buying known as quantitative easing in an effort to boost a lackluster recovery. At the time, Fed staff predicted that inflation would accelerate steadily but very gradually from its 2010 level of 1 percent back toward the 2 percent target. That's pretty much what happened: the core measure of inflation remained below 2 percent in each of the next five years, and was running at 1.4 percent in 2015, just one tenth of a percentage point below the forecast made five years earlier. The unemployment rate stood at 5 percent in late 2015, just 0.2 percentage point below what staff had predicted.
So the Fed’s 2010 forecasts for both inflation and unemployment have proven to be remarkably accurate. Policy makers (including Warsh and me) were briefed on the forecast, which was broadly consistent with the goals that they considered attainable. Policymakers also provided their own long-run projections, in which they assumed that monetary policy would be set appropriately. Most expected the unemployment rate to take at least five to six years to return to its long-run level. Although fewer addressed inflation specifically, their median projection for inflation in 2013 was just 1.5 percent.
In other words, the evidence contradicts Warsh’s claim that the Fed can't manage the economy over time toward its economic objectives. This doesn't mean that the past few years haven't brought any negative surprises. The overall economic capacity of the U.S. is much lower now than the Fed or anyone else expected back in 2010. Would that economic capacity be significantly higher if the central bank had pursued its inflation and unemployment objectives more aggressively, or if it had pursued a different set of objectives entirely? This is the question that the Fed and its staff need to answer.
I focus on core inflation, which excludes food and energy prices, to avoid unpredictable transitory oil-driven fluctuations in headline inflation. The average headline inflation rate was about the same as the average core inflation rate from 2010-2015.
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