More Gas, Not Less

by: Modeled Behavior

By Karl Smith

I see that even Tim Duy is cutting the Fed some slack:

Bottom Line: Another good report, although still suggestive of the beginning of recovery. In my mind, true recovery will come when the cyclical declines in labor force participation are further reversed. At this point, there is no reason for the Fed to pull their foot off the gas. On net though, the employment report does push back the timing of any additional easing. The Fed will move to the sidelines while policymakers assess the level of slack in labor markets. If the cyclical downturn resulted in sustained structural damage, there may be little slack. But if an influx of returning workers puts a floor under the unemployment rate, the Fed will have more work still to do.

If I may be so bold I think the driving intuition behind this type of analysis is that the Fed faces a fundamental trade-off between inflation and unemployment. When the Fed is running near the optimum addressing one concern necessarily raises the marginal costs of the opposing concern and lowers the marginal benefit.

Thus you like breathing room. This allows you to keep the net marginal costs of mis-steps low.

However, the current situation is not like that. The mix of inflation and unemployment is no where near optimum. Inflation is running at or below target, unemployment way above. Furthermore, the risks are highly asymmetric. The principle tool at the Fed’s disposal – the time path of the Fed Funds rate – is backed tight against a lower bound.

Along with high unemployment the US faces a dearth of investment in physical structures: residential, private business, and public. This implies that both the human and physical capital stocks may be falling in per capita terms. Thus, the per capita productive capacity of the United States may be stagnating or even in decline.

In this environment delay in reaching the long term growth path is causing long term losses to the economy.

I have long been of the opinion that the United States was on the cusp of a self-sustaining boom. That boom could have been triggered by fiscal or monetary stimulus or as I believe it turned out, the per capita depreciation of the capital stock to levels that would induce increased investment in housing and durables even without stimulus.

Nonetheless, such a recovery is inherently fragile. In short, the current boost is enough to induce an increase in household formation then we can expect this boom to feed on itself.

However, if not the recovery will miss. Per capita depreciation will be corrected. “Pent-up demand” will be exhausted and the economy will slide back into stagnation.

Thus, given the asymetric nature of risks and the fragility of the current recovery, the marginal benefit of Fed Stimulus is not declining. It is increasing.

The intellectual environment has rightfully become inured to now-more-than-ever-thinking. If I am not calling for the Fed to back-off after a string of 200K+ job reports, when will I make such a call.

Perhaps I care nothing for price stability?

For those who accept it, I can offer my word that this is not true and that until 2007 I consistently favored and argued online for a more hawkish interest rate policy than the one the Fed was pursuing.

For those who do not accept it, I suggest that the truth or falsehood of this position exists independently of the messenger. If you find me intolerably dovish, I understand. Nonetheless, let the public debate address the asymmetric risks on their own merit.