This post is ostensibly about how the Fed does not have its hair on fire about the declining unemployment rate and associated tightening of the labor market. I will get to that extremely obvious point below, even at great risk of boring you.
But what this post is really about is how Fed watchers, including in academia, pay far too much attention – and deference – to what the Fed says, and don’t pay enough attention to what the Fed is doing or what is happening in the actual world.
We saw this in the extreme gullibility around the following claims, among others:
Monetary policy is “extremely accommodative”, whatever that means.
QE is a very potent tool, the use of which requires caution.
In a pinch, the Fed might do h money. LOL
Away from zero bound, policy will basically follow the logic of a Taylor Rule, although the unemployment coefficient and equilibrium real rate estimate are variable.
Inflation expectations are not too low. Rather, the invisible inflation risk premium in the bond market has fallen. And that decline of the invisible inflation risk premium is obviously not something policy needs to react to.
In fairness, there are two forms of gullibility operating here. The first is that the intellectuals believe the Fed believes what it says. And the second, is that they take they Fed’s word as authoritative. That’s the main issue. It is only the specific manifestation of the gullibility that varies.
Which brings me to what this post is meant to be about. Recently Narayana Kocherlakota and Brad Delong have been complaining that the Fed is placing too much emphasis on the presumed establishment of full employment and not enough on the chronic inflation undershoot when setting policy.
Kocherlakota and Delong both make the good point that the level of unemployment (or alternative measures of slack) consistent with full employment is not well known. Amen. I would add that there is some fuzziness around what the concept even means and how that relates to policy. And Kocherlakota – bless him – sees straight through the nonsense claim that the bond market is basically pricing that the Fed will succeed in its stated objective. No it ain’t.
But these guys both pay far too much attention to the Fed’s claims about its intentions to avoid a potentially-destabilizing undershoot of the unemployment rate.
I think the Fed is probably right when it says that a steep decline of the unemployment rate below its “full-employment” level could be destabilizing, even if not accompanied by an immediate rise of inflation. In my view, the Fed leadership is telling a coherent story here.
And the way they are managing that awkward trade-off seems sensible. They are apparently trying to slow the tightening of labor market conditions, but not actually to stop it until they see evidence of a compelling inflation response. This is a hell of a backward looking way to run a railroad, but it beats the others.
Importantly, then, they do not have their hair on fire about falling unemployment, whatever they might say. The labor market has been tightening rapidly in recent months and the Fed is acting as though their intention might be to slow that rate of tightening, certainly not to halt it or reverse it.
The Fed leadership has made the judgment call that raising rates is required to achieve this moderation in the pace of tightening. Or at least that is my judgment of the judgment they are making. We don’t really know: I am just extrapolating ex post results from the past roughly two years of somewhat hawkish Fed talk.
But that’s sort of the point. We don’t really know. Just because the Fed says they are doing something does not mean they are actually doing it? Let me turn this on you, dear reader. Do you think the Fed is acting to stop the decline of unemployment at some horizon relevant to policy decisions today, like Delong and Kocherlakota seem to assume they are?
One final thought. It occurs to me that I might be doing to Delong and Kocherlakota what they are doing to the Fed, that is taking their words too seriously. Maybe D & K know what the Fed is actually doing here, but are trying to swat down hawkish sounding Fed language before it has the chance to do real damage. If so, then it is me who the naïve one, not them.
But they are not important enough for me to do the Vulcan mind meld on. At their current level of influence, I am too lazy to go much beyond what they say, which seems wrong.