Judging by the wrong results

Free from “belonging to the Administration” shackles, Jason Furman weighs in:

Criticism is healthy. Fed decisions are partly informed by the public debate over monetary policy, but ultimately the Fed should be judged by its results. It would be a mistake to limit the Fed’s flexibility and independence by passing legislation that would subject monetary policy to more political interference or increase the use of rules instead of discretion. Smaller changes—like switching to a lower target for inflation or ending data-dependent monetary policy—are also unwarranted.

Americans have benefited from inflation being less responsive to low unemployment rates than usual. But there is a limit, because the same relationship could make it even more costly to reduce above-target inflation. Regardless, the likely higher central target of 0.875% would still be expansionary. I’m glad that Ms. Yellen and her committee colleagues are making independent, data-dependent, discretionary decisions.

The unemployment-inflation nexus is an old but discredited idea. Unfortunately, many at the Fed subscribe. The image below, covering the last 30 years, like an X-Ray, would pick up the presence of a “tumor” if one were there.

It doesn´t. You can see that inflation and unemployment at times fall together. At other times, an increase in unemployment followed by a fall has no bearing on inflation, which remains stable. More recently, a big jump in unemployment is associated with a small drop in inflation, while the subsequent long fall in unemployment is associated with inflation remaining low and stable.

The next image shows there´s a much clearer association between the behavior of nominal spending (NGDP) and unemployment. During those periods where spending growth is stable, unemployment falls. That´s true even for the more recent period when spending growth has been stable at a lower level.

So it´s not the case, as stated by Jason Furman, that inflation has become less responsive to low unemployment rates than usual.

Also, note that it is spending instability, a marked decrease in spending growth that results in unemployment increases, and, like in the recent period, the more gargantuan the spending fall, the stronger the effect on unemployment.

The Fed, like Jason Furman, feels it has attained its objectives of “low inflation” and “maximum employment”. The numbers say it has. What is not widely recognized, however, is that the way it has managed to do so, has deeply hurt the economy.

As the next image show, the Fed has kept the economy in a state of depression. The patient never went through a “recovery” phase before checking out of the hospital. That has seriously damaged, inter alia, the labor market, which despite the low, or “full employment”, rate of unemployment, cannot be described as healthy.

The Fed and many others say that the changes in the labor market are a reflection of structural (mostly demographic) changes, and there´s nothing monetary policy can do about those. Usually, structural changes, in particular demographic changes, evolve slowly, not shock-like as they did in 2008-09.

Maybe at this point, given hysteresis, the economy cannot attain the level of “health” it had before the Fed´s gigantic mistake in 2008, but most certainly monetary policy changes, in particular the adoption of a level targeting rule (a target rule, not an instrument rule like the “Taylor-rule”) can help get it back to a better, more healthy, state.

In a while, the labor market data for February will be available. It can easily turn out to be the case that “good news will be very bad news”! Discretion by the Fed is certainly not working.


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