July 09, 2014
Remember when Treasury Secretary Hank Paulson, Fed Chair Ben Bernanke, and Timothy Geithner, then President of the N.Y. Fed, were running around yelling that the world was about to end? Yeah, that was back in the fall of 2008 when Lehman went under and this trio demanded that Congress immediately cough up $700 billion to bail out the banks or the economy would collapse.
Of course Congress coughed up the dough, but the economy tanked anyhow, albeit probably not as badly if there was no bailout. Anyhow, six years later the economy is still operating at a level of output that is more than 5 percent below its potential, leaving 7 million people needlessly unemployed.
This is important background, because most people might think that the Fed’s failure to stem the growth of the housing bubble, whose inevitable crash sank the economy, was the biggest problem in Fed policy in recent years. After all, tens of millions of people are paying an enormous price for this failure.
But the House Republicans have other ideas. They seem to think the big problem is inflation. Therefore they are proposing the “Federal Reserve Accountability Act.” One of the major items in the Act is a requirement that the Fed follow a Taylor Rule in setting its monetary policy. As specified in the bill, the Fed would be required to set the federal funds rate at a level determined by the gap between potential GDP and actual GDP and the gap between the current inflation rate and the 2.0 percent target inflation rate. The law is intended to sharply limit the Fed’s discretion in adjusting monetary policy to the state of the economy.
There are both technical problems and substantive problems with this approach. On the technical side, the Act doesn’t give guidance as to what the Fed should do when the Act’s formula implies a negative interest rate, as would have been the case at least in 2009 and 2010 when the economy was operating at more than 10 percent below its potential.
The other major technical problem is that potential GDP is poorly measured as evidenced both the large differences between estimates from the OECD, the International Monetary Fund (I.M.F.), and the Congressional Budget Office (CBO). It’s not uncommon for these estimates to be 2-3 percentage points apart. For example, the I.M.F. currently puts the U.S. economy at 3.2 percentage points below potential, while CBO puts the shortfall at more than 5 percent of potential output.
There are also frequent and substantial revisions to potential GDP. CBO’s latest estimate of potential GDP for 2014 is almost 5 percent less than was projected back in 2008, before the downturn. This may reflect actual changes in the economy or it may just be CBO’s perceptions have changed. Applying a Taylor rule based on mis-measured potential GDP can have serious consequences. For example in the late 1990s, the economy proved that its potential output was far larger than CBO and other forecasters had recognized.
If the Fed had followed a Taylor Rule based on the wrong estimates of potential GDP it likely would have choked off growth and prevented the boom and low unemployment of that period. This was the only period since the early 1970s when workers at the middle and bottom of the wage ladder shared in the gains of economic growth.
Perhaps even more important than these objections is the fundamental question of what problem is it that the Republicans hope to solve. We have not had a problem of excessive inflation in this country for three decades. In fact, the inflation rate has been running below the Fed’s two percent target for the last five years.
There are of course many on the right who insist that the government data on inflation is cooked. They also dispute independent sources like M.I.T.’s billion price project which relies on people all over the country entering in prices of goods and services. (Perhaps businesses target right-wingers and charge them much higher prices than the rest of us, since they insist the prices they pay are going through the roof.)
Anyhow, for those of us who don’t believe in the massive grand conspiracy to cook inflation data, it is difficult to understand the obsession with the 2.0 percent inflation target. In the current context, a somewhat higher inflation rate would be a good thing since it would reduce the value of mortgage and student loan debt and reduce real interest rates.
However even in a longer term picture it is difficult to see the fixation with 2.0 percent. Many economies, including the U.S. economy, have had strong growth for decades with moderately higher inflation rates. No one seems bothered when the dollar can rise or fall by 10-15 percent against other currencies in the course of a year. How can it create huge disruptions in the economy if the inflation rate is 3 percent?
The evidence that economists cite to support the 2.0 percent target is remarkably weak. Often studies find no negative effect of moderate inflation on growth and the size of the effect generally reported can easily be explained by measurement error. (An overstatement in our measure of inflation translates directly into an understatement of growth. This means that if our measure of inflation overstates the true rate by 0.5 percentage points annually, then our true rate of growth would be understated by 0.5 percentage points.) In short, there seems little cause for the Fed to pursue a 2.0 percent inflation target as the Holy Grail.
In Getting Back to Full Employment, my book with Jared Bernstein, we argued that the Fed should be prepared to risk a somewhat higher inflation rate in order to allow the unemployment rate to get as low as possible. Obviously we can have rates of inflation that do cause serious disruption to the economy, but we haven’t seen this problem for many decades. We think the gains from allowing millions of people to work, and giving tens of millions the bargaining power to see wage growth, are worth this risk.
Apparently the Republicans in the House have other priorities.
