Federal Reserve Chair Janet Yellen probably jumped at the opportunity to give a keynote speech on Friday at the Federal Reserve Bank of Boston’s conference on “The Elusive Great Recovery.”
Here was a chance before an assembled audience of academics, other central bankers, a Fed watcher or two, and the press to lay out all the questions and issues on her mind, essentially a research agenda for the next year or two, as monetary policy approaches a potentially critical new phase.
*** Chair Yellen’s speech “Macroeconomic Research After the Crisis” was poised as a series of questions and was not intended to signal a newly dovish tilt or change in near policy. Barring a negative shock and the economy staying on its current course, the Federal Open Market Committee is still very likely to raise rates at its December meeting (SGH 9/13/16, “The December Fallback”). That said, one takeaway from her speech, all else being equal, is a probable high bar to a third hike in the policy normalization strategy. ***
*** Chair Yellen’s “plausible ways” question — whether it might be possible to reverse some of the structural damage to potential output by running a “high pressure” economy for a while at full employment — essentially sums up the Fed’s policy since the depth of the crisis and which she described in her 2012 “optimal control” speeches. And going forward, Yellen was posing as questions the bet the Fed is now making whether to let the economy run hot for a while longer to soak up the surprise slack that still seems to be in the labor market. ***
*** There are risks to the strategy, she concedes, in that inflation could rise more quickly than the inertial, expectations-anchored pace currently forecast. To safeguard against an upside inflation surprise, Yellen’s cautiously constructed “sooner and slower” policy normalization strategy is the insurance against the risk of an excessive overshoot of the 2% inflation target. Gradually nudging rates up as the labor market continues to tighten narrows the gap between a still accommodative policy rate and the persistently low equilibrium rate. ***
Lack of Demand Creates Lack of Supply
The key first question raised in Yellen’s speech on the influence of demand on aggregate supply draws heavily from a 2013 paper written by David Reifschneider, William Wascher, and David Wilcox on “Aggregate Supply in the US: Recent Developments and Implications for the Conduct of Monetary Policy.” In their influential paper, the trio of senior Board staff estimated a massive 7% loss of output and a substantial supply-side damage in the wake of the 2008-2009 financial crisis, leaving real growth to trail trend growth more or less by that amount ever since.
But they argued that at least some of that lost potential growth was due to substantially inadequate demand, or cyclically-driven, and the supply side damage could in theory be reversed before it became more structural — or secular in the current vernacular — in lost labor skills, productive capacity, and subsequently lower productivity growth, if monetary policy was aggressive enough, quick enough, and sustained for long enough.
The paper, and indeed, the thrust of Fed policy in recent years, is threaded with these fears of an economy slipping into the sort of secular stagnation described by Harvard University’s Lawrence Summers. And like his arguments for a mix of monetary and mostly fiscal policy to stimulate demand, Yellen references in a footnote to her speech a “reverse Say’s Law” that Summer cites, that lack of demand creates lack of supply.
The 2013 staff paper also carried a caveat, which Yellen likewise cited in Friday’s speech, that the stimulative monetary policy, if carried on for too long, entails a major risk in that inflation could rise faster than expected or to persist for longer than desired.
Indeed, a cornerstone to Yellen’s strategy is an inertial inflation and what seems to be a weakened influence between labor market conditions and inflation, certainly compared to most modeled assumptions prior to the crisis. Instead of slipping into outright deflation in the wake of the crisis, inflation at the time went mostly sideways at around 1%. It has likewise proven to be pretty inertial on the upside, barely moving upward through the years of the admittedly tepid recovery but with unemployment falling by half and near its assumed longer run levels.
Yellen concedes in her third question poised in the speech that the dynamics of the inflation process are still not well understood. And that is evident in the Fed having consistently overestimated its level even while underestimating the fall in the unemployment rate.
But while the persistence in low inflation remains a key concern for the Fed, the majority of the FOMC are still confident that as long as the economy is growing above trend, the tightening of the labor market will mean that inflation, in time, will inevitably rise towards mandate-consistent levels.
Probing for Full Employment
In the meantime, what Yellen seems to be rhetorically asking is whether inflation that, somewhat surprisingly, is still so stable, is an opportunity for the Fed to probe a bit longer and further with an accommodative policy to see just where NAIRU truly lies.
Perhaps it is either even lower at perhaps no more than 4.5% or 4.6% or, judging from the modest upticks in the labor participation rate this year, there are a lot more workers out there who can be drawn into the labor force if the economy is allowed to run at a “high pressure” pace for a while longer.
As long as inflation remains dampened and under its 2% symmetrical target, in other words, the Fed would be failing its other mandate on employment if did not use the current circumstances to let the economy run a little hot at or near full employment.
The pay off in the Yellen-led strategy is to engineer a repeat of sorts to former Fed Chairman Alan Greenspan’s rapid growth, full employment, and low inflation of the late 1990s. The bet Greenspan so famously made was that there was a higher than understood productivity at the time that would temper price pressures. It led him to resist the pressure from many of his fellow FOMC members (including a then Governor Yellen) to raise rates in 1997.
Instead, a pass on a new rate tightening opened the door to the employment gains that saw the unemployment rate drop all the way down to 3.9% amid a near 4% real growth, with tempered inflation. To be sure, the no-show of significant inflation had a strong tailwind behind it in the deflationary pressures of the Asian crisis, but Yellen’s takeaway from the “fabulous decade” was in avoiding a premature policy tightening before the true limits of full employment could be tested.
And just as Greenspan’s hunch on as yet measured productivity gains was key to the performance of the economy by the end of that decade, Yellen’s bet is that the same may come from the hidden slack in the labor market that will prove to keep inflation in check for long enough to allow the Fed to probe for the true full employment.
And the real eyes on the prize in a “high pressure” economy operating at full employment is to trigger the increase in business capital spending that has been absent nearly throughout the tepid recovery. In time, it could start to reverse the decline in productivity and even lift the economy’s trend growth again (for an earlier discussion, see SGH 4/22/14, “Fed: Twists and Turns”).
Policy Normalization Insurance
It is our sense then that Yellen’s policy strategy, more or less mapped out in the four research questions she put to her audience on Friday, is to find a balance in both policy and in crafting a Committee consensus through the policy normalization strategy that has been in play since last year.
On the one side of the cost/benefit ledger is a replay of that late 1990s willingness to probe for NAIRU and where the “new normal” of the lower than normal effective equilibrium policy rate is, but on the other side of the ledger, as befitting Yellen’s cautious nature, to take out a protective insurance policy against running too hot for too long by gradually raising the policy rate — and which also keeps the Committee’s more hawkish-inclined on board.
What’s more, by starting to raise rates a bit sooner than would be the case when inflation is still so low, policy normalization protects the safety of a gradual trajectory. That gradual ascent is the Fed’s best means of limiting the risk of either overrunning the neutral rate or being forced by an upside inflation shock to raise rates so rapidly it derails the recovery or dislocates the financial markets. At the same time, moving so cautiously provides some protection against a premature tightening that growth barely above trend stalls or softens to a subpar pace.
That was essentially the basis for Federal Reserve Bank of Boston President Eric Rosengren’s rare dissent at the September meeting, a marker on the merits of this policy normalization strategy, and a gentle reminder against letting the policy probing run so long it risks an overshoot of the employment mandate and a rapid escalation of rates that brings the whole policy — and the recovery — to an end. As we noted previously (SGH 10/12/16, “Fed: A Mighty Debate”), we suspect Chair Yellen sympathized with the dissent.
And in the balancing act of the cautious policy path over the last year, there is likewise no conflict seen in the dissent and the September decision to pass on a rate move. Nor indeed is there a contradiction between a likely second rate hike in December and the loftier ambitions for a high pressure run of the economy for a bit longer that draws more workers into the labor force, with all the social and economic benefits it brings.