The Fed Has Lots Of Credibility; Will They Use It Wisely?

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Here's Janet Yellen:

The Federal Reserve may need to run a "high-pressure economy" to reverse damage from the 2008-2009 crisis that depressed output, sidelined workers, and risks becoming a permanent scar, Fed Chair Janet Yellen said on Friday in a broad review of where the recovery may still fall short.

Though not addressing interest rates or immediate policy concerns directly, Yellen laid out the deepening concern at the Fed that U.S. economic potential is slipping and aggressive steps may be needed to rebuild it.

I see this as a big mistake. The Fed needs to focus on smoothing out the path of nominal spending. There's not much they can do about the economy's "potential", and trying to boost it would end up destabilizing the economy. Back in the 1960s, the Fed also believed there was a permanent trade-off between inflation and unemployment - it did not end well.

Yellen's comments, while posed as questions that need more research, still add an important voice to an intensifying debate within the Fed over whether economic growth is close enough to normal to need steady interest rate increases, or whether it remains subpar and scarred, a theory pressed by Harvard economist and former U.S. Treasury Secretary, Lawrence Summers, among others.

Her remarks jarred the U.S. bond market on Friday afternoon, where they were interpreted as perhaps a willingness to allow inflation to run beyond the Fed's 2.0 percent target. Prices on longer dated U.S. Treasuries, which are most sensitive to inflation expectations, fell sharply and their yields shot higher.

Yellen's statement was not an indication of Fed policy, but merely the musings of one person. It's very unlikely to be put into action. And yet, bond prices plunged. Now imagine if all 12 members of the FOMC got on a stage and said they were raising the inflation target from 2% to 3%. The impact on the bond market would have been at least 10 times greater than what occurred on Friday. There's no question that the Fed can move inflation expectations; the question is what should they be doing? Credibility has never been the Fed's problem. In late 2008, the Fed's contractionary policy was highly credible - markets saw where the Fed was pushing NGDP. In 2009-10, their explicit decision not to return NGDP to the old trend line was highly credible.

Jeffrey Gundlach, chief executive of DoubleLine Capital, said he read Yellen as saying, "'You don't have to tighten policy just because inflation goes to over 2 percent.'

"Inflation can go to 3 percent, if the Fed thinks this is temporary," said Gundlach, who agreed Yellen was striking a chord similar to Summer's "secular stagnation" thesis. "Yellen is thinking independently and willing to act on what she thinks."

It would be destabilizing to let inflation go to 3% while unemployment is low. It would bring the recovery to a premature end, triggering another recession as soon as the economy was hit by another oil shock. Instead, the Fed should shoot for 3% inflation during the next recession - not during this expansion. But they currently lack a policy regime capable of achieving that (countercyclical) outcome. Yellen's policy remains resolutely procyclical. NGDPLT, anyone?

"If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand," Yellen said. It would "make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn."

That's a really big "if", which goes against 50 years of macroeconomic research. That doesn't mean it's wrong - we learn new things all the time. But this theory is not even close to being ready to implement. At a minimum, we'd need many years of research and testing of the idea before using the US economy as a test tube for Yellen's latest theory.

PS. Commenters invariably tell me that easier money leads to more investment and, hence, more growth. Do you really believe macroeconomists haven't been aware of that? The problem is that it doesn't boost the economy's long-term growth rate, and hence creates more cyclical instability. It might be helpful to consider "investment" as "home building" - one of its biggest components. It's true that even today, the flow of housing services from homes is larger than it might have been without all those homes built during the 2003-06 boom. Does the mean the 2003-06 housing boom boosted the long-term growth rate of the US? Did it help to stabilize the US economy?

PPS. Don't take this post as a criticism of Yellen's current policy stance within the Fed. I don't have a problem with her recent votes (not to raise rates).

PPPS. I have a related post at Econlog, which discusses the issue of credibility and inflation expectations.

HT: TravisV

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