A Question For the Fed: There is a near-consensus at the FOMC that rates must eventually move up. But here’s my question: why, exactly? Specifically, which component of aggregate demand do we believe will continue to strengthen in a way that will require monetary tightening to avoid an overheating economy?
Here’s a look at two obvious candidates...
Nonresidential investment has basically recovered from the recession-induced slump. Residential investment is still a bit low by historical standards, but not as much as you might think if your baseline is the boom of the mid-naughties. And given the slowing growth of the working-age population — down from more than 1 percent a year to less than 0.5 — should’t we expect some reduction in home construction?
So I don’t see an obvious reason to believe that current rates are too low. Yes, they’re near zero — but that in itself doesn’t mean too low.
Like others, notably Larry Summers, I think the Fed is trying to return to a normality that is no longer normal.
Forecasting that the Unemployment Rate will stay Constant is a Bad Idea: Jim Bullard, President of the St Louis Fed, has released a new, St Louis Fed model, for thinking about the way the Fed forecasts. According to the St Louis model, we should think about 'regimes'. There are three components to regimes. 1) Is the economy in a recession: YES or NO? 2) Is the short-term real interest rate HIGH or LOW? 3) Is productivity growth HIGH or LOW?
Putting these pieces together, there are eight possible states. Recession can be YES or NO, productivity can be HIGH or LOW and the natural real interest rate (Jim calls this R Dagger) can be HIGH or LOW.
In Bullard's view the current regime is Recession: NO, Productivity growth: LOW, R Dagger: LOW
Using regime dependent forecasting, Jim thinks the best forecast of the US economy, moving forwards, is that productivity growth will stay low and the unemployment rate will stay where it is. That implies, according to Bullard, that the Fed should hold the interest rate at 63 basis points through 2018.
I have one big problem with this forecasting framework..., there is no period in the post-war period when the unemployment rate was even approximately constant. It was either increasing or it was decreasing. If we stick with the regime dependent paradigm, I would replace, [Recession = Yes or NO], with, [Unemployment = INCREASING or DECREASING].
That may seem like a semantic change. But it makes a big difference to a regime dependent forecasting model because the unemployment rate cannot keep falling forever. That suggests that, the longer we are in the [Unemployment = DECREASING] state, the higher is the probability of a regime switch into [Unemployment = INCREASING]. That suggests to me, that the risk of another recession while productivity and the natural real interest rate are low is higher than Jim Bullard thinks. ...
From an interview of Lars Svensson:
...Eugenio Cerutti: How much can countries rely on monetary policy to lead the recovery from the global financial crisis?
Lars Svensson: I think monetary policy can do more in the United States, Japan, and the euro zone. One can get policy rates further into the negative range, and one can avoid premature liftoffs. Particularly in the euro zone, monetary policy can and should do more. ... Fiscal policy could do more. There are some countries where fiscal policy is unsustainable, but in other countries, fiscal policy can definitely be more expansionary. In terms of monetary policy, there are still things that haven’t been tried, such as monetary financing of government expenditures. Monetary financing of government expenditures should definitely work in increasing nominal aggregate demand, and thereby increasing both real activity and inflation.