The Fed Is Planning for Another Slow Recovery
Last month, U.S. Federal Reserve Chair Janet Yellen gave an important address at the Jackson Hole public-policy conference. She argued in part that, thanks to its new tools of forward guidance and long-term asset purchases, the Fed would be able to offset the next recession, even if interest rates eventually stabilized at historically low levels. (Her assessment was criticized by others, perhaps most notably by Larry Summers, as unduly optimistic.)
Yellen’s speech reveals that the Fed remains dangerously unwilling to pursue with appropriate vigor its objectives of 2 percent inflation and maximum employment.
Yellen accompanied her speech with an elegant slide show. Her third figure was taken from a recent working paper by long-time Fed staff economist David Reifschneider:
These charts are generated from the Fed’s baseline model. The black line in each one represents the outcome of the Fed’s response to a recession by using what Yellen terms an “aggressive” policy rule for its target interest rate, along with forward guidance and asset purchases. She views this black-line outcome as a demonstration that the Fed’s existing tools would be “sufficient” (to use her word) for the Fed’s purposes.
It’s worth thinking carefully about Yellen’s statement. The black line in the bottom left panel shows that the unemployment rate would remain above 5 percent for four years. The black line in the bottom right panel shows that the inflation rate would be below the Fed’s target of 2 percent for more than a decade.
Two years into this hypothetical recession, the Fed would be refusing to provide more accommodation, even though the unemployment rate would be above 9 percent and it would be expecting the inflation rate to be falling further below its target for another three years. (And as I have written, at this point in the recession, the unemployment rate among blacks would likely be above 17 percent.)
How can the Fed view these unemployment and inflation outcomes as acceptable? One answer is that the Fed can’t do any better. But inside the model used to generate Yellen’s slide, the Fed can always push down the unemployment rate and raise the inflation rate by promising to keep its target interest rate lower for longer, buying more long-term assets or both.
The inflation and unemployment outcomes depicted by Yellen represent the Fed’s desires (as modeled by its staff), not its limitations. (Indeed, elsewhere in his paper, Reifschneider depicts how the Fed could do significantly better.)
There are big risks with the Fed using this kind of deliberate approach to its mandates. Planning to miss the inflation target for more than a decade creates risks for the credibility of that target. Planning for four years of slack weakens the connection between many workers and the labor market, risking the long-term health of the labor market.
Perhaps worst of all, many would interpret these outcomes to mean that monetary policy is an ineffective tool with which to influence either prices or employment.
How can we fix this problem? The Fed ultimately reports to us, the voters, through the oversight provided by Congress and the president. Our representatives should be holding the Fed much more publicly accountable for achieving its mandates in a timely fashion. And in this election year, voters should be seeking candidates who will be willing to impose that kind of accountability.
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