Bernanke On The Fed's New View Of The Economy

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Ben Bernanke has a post discussing the Fed's evolving view of the economy:

I'll focus here on FOMC participants' longer-run projections of three variables-output growth, the unemployment rate, and the policy interest rate (the federal funds rate)-and designate these longer-run values by y*, u*, and r*, respectively. Under the interpretation that these projections equal participants' estimates of steady-state values, each of these variables is of fundamental importance for thinking about the behavior of the economy:

  • Projections of y* can be thought of as estimates of potential output growth, that is, the economy's attainable rate of growth in the long run when resources are fully utilized

  • Projections of u* can be viewed as estimates of the "natural" rate of unemployment, the rate of unemployment that can be sustained in the long run without generating inflationary or deflationary pressures

  • Projections of r* can be interpreted as estimates of the "terminal" or "neutral" federal funds rate, the level of the funds rate consistent with stable, noninflationary growth in the longer term

He then explains how over the past few years the Fed has tended to consistently overestimate these variables:

Why are views shifting? The changing views of FOMC participants (and of most outside economists) follow pretty directly from persistent errors in forecasting economic developments in recent years:As the table shows, FOMC participants have been shifting down their estimates of all three variables-y*, u*, and r*-for some years now.

Notice that there is no mention of the fact that the markets, and hence market monetarists, have generally been more accurate than the Fed. We take financial market predictions seriously, and thus immediately discounted the Fed forecast of 4 rate increases in 2016, made back in December. Indeed for years I've been arguing that the Fed's dot plot is too optimistic about the Fed's ability to raise interest rates under its current policy regime.

More than two years ago I suggested that 3% NGDP growth and 1.2% RGDP growth were the new normal, at a time when the Fed was still forecasting considerably higher rates. Bernanke says the lower natural GDP growth rate is partly due to surprisingly low productivity growth. Back in 2011, I suggested that we were having a "job-filled non-recovery," just the opposite of the jobless recovery being discussed by many pundits. Since then we've continued to have a job-filled non-recovery, with faster than expected job creation and a fast falling unemployment rate, accompanied by slower than expected RGDP growth. This is just another way of saying that productivity growth has been lousy (indeed negative for three quarters in a row.)

It's nice that the Fed is finally seeing the light on issues that market monetarists have been emphasizing for many years. But I'd feel better if they took this as a lesson that they need to change their entire operating system, and start relying much more on market forecasts.

Back in 1997, Bernanke published a paper with Michael Woodford (in the JMCB) suggesting that market forecasts could be useful to policymakers, if they revealed information about the impact of different monetary policy instrument settings. OK, so why doesn't the Fed take Bernanke's advice and create a set of prediction markets for inflation and output, one for each plausible instrument setting.

P.S. By "job-filled non-recovery" I did not mean that we were not getting closer to the natural rate, I meant we are not recovering in the sense of going back to the old trend line. Clearly, the labor market has been gradually recovering.

HT: Bill Beach, Patrick Horan