Economist's View

The Goals of Monetary Policy and How We Pursue Them

Janet Yellen:

The Goals of Monetary Policy and How We Pursue Them: ...it's fair to say, the economy is near maximum employment and inflation is moving toward our goal. The unemployment rate is less than 5 percent, roughly back to where it was before the recession. And, over the past seven years, the economy has added about 15-1/2 million net new jobs. Although inflation has been running below our 2 percent objective for quite some time, we have seen it start inching back toward 2 percent last year as the job market continued to improve and as the effects of a big drop in oil prices faded. Last month, at our most recent meeting, we took account of the considerable progress the economy has made by modestly increasing our short-term interest rate target by 1/4 percentage point to a range of 1/2 to 3/4 percent. It was the second such step--the first came a year earlier--and reflects our confidence the economy will continue to improve.

Now, many of you would love to know exactly when the next rate increase is coming and how high rates will rise. The simple truth is, I can't tell you because it will depend on how the economy actually evolves over coming months. The economy is vast and vastly complex, and its path can take surprising twists and turns. What I can tell you is what we expect--along with a very large caveat that our interest rate expectations will change as our outlook for the economy changes. That said, as of last month, I and most of my colleagues--the other members of the Fed Board in Washington and the presidents of the 12 regional Federal Reserve Banks--were expecting to increase our federal funds rate target a few times a year until, by the end of 2019, it is close to our estimate of its longer-run neutral rate of 3 percent. ...

Recent Economic Developments and Longer-Run Challenges

Federal Reserve Governor Jerome Powell (for a more optimistic take on the "new normal," see Is Our Economic Future Behind Us? by Joel Mokyr):

Recent Economic Developments and Longer-Run Challenges: ...Longer-Run Challenges Productivity and Growth

Let's turn to longer-run challenges, and start by asking why growth has been so slow, and how fast we are likely to grow going forward. This next slide shows the five-year trailing average annual real GDP growth rate (figure 8). By this measure, growth averaged about 3.2 percent annually through the 1970s, the 1980s, and the 1990s. But growth began to decline after 2000 and then nose-dived with the onset of the Global Financial Crisis in 2007 and the slow expansion that followed. Since the financial crisis ended in 2009, forecasters have gradually reduced their estimates of long-run trend growth from about 3 percent to about 2 percent--a seemingly small difference that would make a huge difference in living standards over time.³ 

How much of this decline is just a particularly bad business cycle, and how much represents a long-run downshift? To get at that question, let's take a deeper look at the growth slowdown. We can think of economic growth as coming from two sources: more hours worked (labor supply) or higher output per hour (productivity). Hours worked mainly depends on growth in the labor force, which has been slowing since the mid-2000s as the baby-boom generation ages. As you can see, the labor force is now growing at only about 0.5 percent per year (figure 9). Another way to see this is through the sustained increase in the ratio of people over 65 to those who are in their prime working years (figure 10). This long-expected demographic fact has now arrived, and it has challenging implications for our potential growth and also for our fiscal policy.⁴ 

The unexpected part of the growth slowdown reflects weak productivity growth rather than lower labor supply. Labor productivity has increased only 1/2 percent per year since 2010--the smallest five-year rate of increase since World War II and about one-fourth of the average postwar rate (figure 11). The slowdown in productivity has been worldwide and is evident even in countries that were little affected by the crisis (figure 12). Given the global nature of the phenomenon, it is unlikely that U.S.-specific factors are mainly responsible.

A portion of the productivity slowdown is undoubtedly due to low levels of investment by businesses. The financial crisis and the Great Recession left firms with excess capacity, reducing incentives to invest. If businesses expect slower growth to continue, that will also hold down investment.

The other important factor is the decline in what economists call total factor productivity, or TFP, which is the part of productivity that is not explained by capital investment or increases in the skills of the labor force. TFP is thought to be mainly a function of technological innovation and efficiency gains.

There is no consensus about the future direction of productivity.⁵ The pessimists argue that the big paradigm-changing innovations, such as electrification or the advent of computers, are behind us. If that is so, then our standard of living will increase more slowly going forward. The optimists think that this slowdown is only a passing phase and that the age of robots and machine learning will transform our economy in coming decades. Still others argue that we are currently underestimating productivity and output because of the real difficulties we face in measuring GDP in a modern economy. For example, how do we measure the value-added of free digital services like Facebook or Twitter?⁶ 

The future is, as always, uncertain. But I would sum up the growth discussion as follows. Growth in the labor force has slowed, and we can estimate it with reasonable confidence to be only about 0.5 percent. Growth in productivity is both more important and much harder to predict. Productivity varies significantly over time, as figure 11 showed. If productivity growth returns to, say, 1.5 percent, then the U.S. economy could grow at about 2.0 percent over the long term. Actual growth may turn out to be weaker or stronger, and the choices we make as a society will have something to say about that.

Why Are Long-Term Interest Rates So Low?

Let's turn to the related question of why long-term interest rates are so extraordinarily low in advanced economies around the world. The yield on our own benchmark 10-year U.S. Treasury security has increased lately, but at 2.3 percent it is still far below what was normal before the financial crisis. In fact, this next chart shows that, as growth and inflation have fallen, longer term interest rates have fallen as well over the past 35 years (figure 13).

So why are long-term interest rates so low? Many of you will no doubt be thinking, "They are low because you people at the Fed set them low!" While there is an element of truth there, that is not the whole story. The FOMC has considerable control over short-term interest rates. We have much less influence over long-term rates, which are set in the marketplace. Long-term interest rates represent the price that balances the supply of saving by lenders and demand for funds by borrowers, such as businesses needing to fund their capital expenditures. Lenders expect to receive a real return and to be compensated for inflation and for the risk of nonpayment. Meanwhile, borrowers adjust their demand for funds based on their changing assessment of the risks and expected returns of their investment projects. When desired saving rises or investment demand falls, then long-term interest rates will decline. Today's very low level of long-term rates suggests that both of these factors are at play.

Both expectations of slower growth and the aging of our population are having significant effects on desired saving and investment and are thus important causes of lower interest rates. If the economy is expanding more slowly, then the level of investment needed to meet demand will be lower. The lower path of growth reduces future income prospects of households, and they will tend to raise their saving. The pending retirement of baby boomers means higher saving, because people tend to save the most in the years just before their retirement. In addition, the lower rate of return on capital owing to lower productivity growth will lead to less investment and lower interest rates.

As with productivity, the factors behind the fall in U.S. interest rates include an important global component, as rates are low around the world. Indeed, although our rates are near historical lows, U.S. Treasury rates are among the highest among the major advanced economy sovereigns (figure 14).

Is This the New Normal?

What can we do to prevent low growth, low inflation, and low interest rates from becoming the new normal? We need to focus on ways to increase our long-term growth and spread that prosperity as broadly as possible. I hasten to add that these policies are, for the most part, outside the purview of the Federal Reserve. We need policies that support productivity growth, business hiring and investment, labor force participation, and the development of skills. We need effective fiscal and regulatory policies that inspire public confidence. Increased spending on public infrastructure may raise private-sector productivity over time, particularly with the growth of the stock of public infrastructure near an all-time low.⁷ Greater support for public and private research and development, and policies that improve product and labor market dynamism may also be fruitful.⁸ Monetary policy can contribute by supporting a strong and durable expansion in a context of price stability.

Monetary Policy
The low interest rate environment presents special challenges for monetary policy. In setting our target for the federal funds rate, a good place to start is to identify the rate that would prevail if the economy were at 2 percent inflation and full employment--the so-called neutral rate. "Neutral" in this context means that the rate is neither contractionary nor expansionary. If the fed funds rate is lower than the neutral rate, then policy is stimulative or accommodative, which will tend to raise growth and inflation. If the fed funds rate is higher than the neutral rate, then policy is tight and will tend to slow growth and reduce inflation.

But we can only estimate the neutral rate, and those estimates are subject to substantial uncertainty. Before the crisis, the long-run neutral rate was generally thought to be roughly stable at around 4.25 percent. Since the crisis, estimates have steadily declined, and the median estimate by FOMC participants stood at 2.9 percent in September. Many analysts believe that the neutral rate is even lower than that today and will only return to its long-run value over time.⁹ The low level of the neutral interest rate has several important implications. First, today's low rates are not as stimulative as they seem--consider that, despite historically low rates, inflation has run consistently below target and housing construction remains far below pre-crisis levels. Second, with rates so low, central banks are not well positioned to counteract a renewed bout of weakness. Third, persistently low interest rates can raise financial stability concerns. A long period of very low interest rates could lead to excessive risk-taking and, over time, to unsustainably high asset prices and credit growth. These are risks that we monitor carefully. Higher growth would increase the neutral rate and help address these issues.

Turning to the outlook for monetary policy, incoming data show an economy that is growing at a healthy pace, with solid payroll job gains and inflation gradually moving up to 2 percent. In my view, the case for an increase in the federal funds rate has clearly strengthened since our previous meeting earlier this month. Of course, the path of rates will depend on the path of the economy. With inflation below target, relatively slow growth, and some slack remaining in the economy, the Committee has been patient about raising rates. That patience has paid dividends. But moving too slowly could eventually mean that the Committee would have to tighten policy abruptly to avoid overshooting our goals.

Conclusion
To wrap up, since the end of the Great Recession in 2009, our economy has recovered slowly but steadily. Today, we are reasonably close to achieving full employment and our 2 percent inflation objective. But we face real challenges over the medium and longer terms. Our aging population will mean slower growth, all else held equal. If living standards are to continue to rise, we need policies that will support productivity and allow our dynamic economy to generate widespread gains in prosperity.

Yellen: The Economic Outlook

Federal Reserve Chair Janet L. Yellen:

The Economic Outlook, Before the Joint Economic Committee, U.S. Congress, Washington, D.C., November 17, 2016: ...The U.S. economy has made further progress this year toward the Federal Reserve's dual-mandate objectives of maximum employment and price stability. Job gains averaged 180,000 per month from January through October, a somewhat slower pace than last year but still well above estimates of the pace necessary to absorb new entrants to the labor force. The unemployment rate, which stood at 4.9 percent in October, has held relatively steady since the beginning of the year. The stability of the unemployment rate, combined with above-trend job growth, suggests that the U.S. economy has had a bit more "room to run" than anticipated earlier. ...

While above-trend growth of the labor force and employment cannot continue indefinitely, there nonetheless appears to be scope for some further improvement in the labor market. ... Further employment gains may well help support labor force participation as well as wage gains; indeed, there are some signs that the pace of wage growth has stepped up recently. While the improvements in the labor market over the past year have been widespread across racial and ethnic groups, it is troubling that unemployment rates for African Americans and Hispanics remain higher than for the nation overall, and that the annual income of the median African American household and the median Hispanic household is still well below the median income of other U.S. households.

Meanwhile, U.S. economic growth appears to have picked up from its subdued pace earlier this year. ...

Turning to inflation... Core inflation, which excludes the more volatile energy and food prices and tends to be a better indicator of future overall inflation, has been running closer to 1-3/4 percent.

With regard to the outlook, I expect economic growth to continue at a moderate pace sufficient to generate some further strengthening in labor market conditions and a return of inflation to the Committee's 2 percent objective over the next couple of years. ... As the labor market strengthens further and the transitory influences holding down inflation fade, I expect inflation to rise to 2 percent.

Monetary Policy I will turn now to the implications of recent economic developments and the economic outlook for monetary policy. The stance of monetary policy has supported improvement in the labor market this year, along with a return of inflation toward the FOMC's 2 percent objective. In September, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent and stated that, while the case for an increase in the target range had strengthened, it would, for the time being, wait for further evidence of continued progress toward its objectives.

At our meeting earlier this month, the Committee judged that the case for an increase in the target range had continued to strengthen and that such an increase could well become appropriate relatively soon if incoming data provide some further evidence of continued progress toward the Committee's objectives. This judgment recognized that progress in the labor market has continued and that economic activity has picked up from the modest pace seen in the first half of this year. And inflation, while still below the Committee's 2 percent objective, has increased somewhat since earlier this year. Furthermore, the Committee judged that near-term risks to the outlook were roughly balanced.

Waiting for further evidence does not reflect a lack of confidence in the economy. Rather, with the unemployment rate remaining steady this year despite above-trend job gains, and with inflation continuing to run below its target, the Committee judged that there was somewhat more room for the labor market to improve on a sustainable basis than the Committee had anticipated at the beginning of the year. Nonetheless, the Committee must remain forward looking in setting monetary policy. Were the FOMC to delay increases in the federal funds rate for too long, it could end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of the Committee's longer-run policy goals. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and ultimately undermine financial stability.

The FOMC continues to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain maximum employment and price stability. This assessment is based on the view that the neutral federal funds rate--meaning the rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel--appears to be currently quite low by historical standards. ... With the federal funds rate currently only somewhat below estimates of the neutral rate, the stance of monetary policy is likely moderately accommodative, which is appropriate to foster further progress toward the FOMC's objectives. But because monetary policy is only moderately accommodative, the risk of falling behind the curve in the near future appears limited, and gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.

Of course, the economic outlook is inherently uncertain, and, as always, the appropriate path for the federal funds rate will change in response to changes to the outlook and associated risks.

Yellen: The Outlook, Uncertainty, and Monetary Policy

The end of Janet Yellen's speech today:

...The FOMC left the target range for the federal funds rate unchanged in January and March, in large part reflecting the changes in baseline conditions that I noted earlier. In particular, developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December.

Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC's ability to use conventional monetary policy to respond to economic disturbances is asymmetric. If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.⁹

One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment. Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy--specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.¹⁰ While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.¹¹

Of course, economic conditions may evolve quite differently than anticipated in the baseline outlook, both in the near term and over the longer run. If so, as I emphasized earlier, the FOMC will adjust monetary policy as warranted. As our March decision and the latest revisions to the Summary of Economic Projections demonstrate, the Committee has not embarked on a preset course of tightening. Rather, our actions are data dependent, and the FOMC will adjust policy as needed to achieve its dual objectives.

Financial market participants appear to recognize the FOMC's data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks. This mechanism serves as an important "automatic stabilizer" for the economy. As I have already noted, the decline in market expectations since December for the future path of the federal funds rate and accompanying downward pressure on long-term interest rates have helped to offset the contractionary effects of somewhat less favorable financial conditions and slower foreign growth. In addition, the public's expectation that the Fed will respond to economic disturbances in a predictable manner to reduce or offset their potential harmful effects means that the public is apt to react less adversely to such shocks--a response which serves to stabilize the expectations underpinning hiring and spending decisions.¹²

Such a stabilizing effect is one consequence of effective communication by the FOMC about its outlook for the economy and how, based on that outlook, policy is expected to evolve to achieve our economic objectives. I continue to strongly believe that monetary policy is most effective when the FOMC is forthcoming in addressing economic and financial developments such as those I have discussed in these remarks, and when we speak clearly about how such developments may affect the outlook and the expected path of policy. I have done my best to do so today, in the time you have kindly granted me.

Reflections on Macroeconomics Then and Now

Stanley Fischer:

Reflections on Macroeconomics Then and Now: I am grateful to the National Association for Business Economics (NABE) for conferring the fourth annual NABE Paul A. Volcker Lifetime Achievement Award for Economic Policy on me, thereby allowing me the honor of following in the footsteps of Paul Volcker, Jean-Claude Trichet, and Alice Rivlin.¹ The honor of receiving the award is enhanced by its bearing the name of Paul Volcker, a model citizen and public servant, and a giant in every sense among central bankers.

One thinks of many things on an occasion such as this one. My mind goes back first to growing up in a very small town in Zambia, then Northern Rhodesia, and to the surprise and delight my parents would have felt at seeing me standing where I am now. They would have been even more delighted that my girlfriend, Rhoda, whom I met when my parents moved to a bigger town in Zimbabwe, and I have been happily married for 50 years. But that is not the story I will tell today. Rather, I want to talk about our field, macroeconomics, and some of the lessons we have learned in the course of the last 55 years--and I say 55 years, because in 1961, at the end of my school years, on the advice of a friend, I read Keynes's General Theory for the first time.

Did I understand it? Certainly not. Was I captivated by it? Certainly, though "captured" is a more appropriate word than "captivated." Does it remain relevant? Certainly. Just a week ago I took it off the bookshelf to read parts of chapter 23, "Notes on Mercantilism, the Usury Laws, Stamped Money and Theories of Under-Consumption." Today that chapter would be headed "Protectionism, the Zero Lower Bound, and Secular Stagnation," with the importance of usury laws having diminished since 1936.

There is an old joke about our field--not the one about the one-handed economist, nor the one about "assume you have a can opener," nor the one that ends, "If I were you, I wouldn't start from here." Rather it's the one about the Ph.D. economist who returns to his university for his class's 50th reunion. He asks if he can see the most recent Ph.D. generals exam. After a while it is brought to him. He reads it carefully, looking perplexed, and then says, "But this is exactly the same as the exam I wrote over 50 years ago." "Ah yes," says the professor. "It is the same, but all the answers are different."

Is that really the case? Not really, though it is true to some extent in the realm of policy. To discuss the question of whether the answers to the questions of how to deal with macroeconomic policy problems have changed markedly over the past half-century or so, I will start by briefly sketching the structure of a basic macro model. The building blocks of this model are similar to those used in many macro models, including FRB/US, the Fed staff's large-scale model, and a variety of DSGE (dynamic stochastic general equilibrium) models used at the Fed and other central banks and by academic researchers.

The structure of the model starts with the standard textbook equation for aggregate demand for domestically produced goods, namely:²

1. AD = C + I + G + NX;
2. Next is the wage-price block, which is based on a wage or price Phillips curve. Okun's law is included to make the transition between output and employment;
3. Monetary policy is described by a money supply or interest rate rule;
4. The credit markets and financial intermediation are built off links between the policy interest rate and the rates of return on, and/or demand and supply functions for, other assets;
5. The balance of payments and the exchange rate enter through the balance of payments identity, namely that the current account surplus must be equal to the capital account deficit, corrected for official intervention;
6. Dynamics of stocks: There are dynamic equations for the capital stock, the stock of government debt, and the external debt.

When I was an undergraduate at the London School of Economics (LSE) between 1962 and 1965, we learned the IS-LM model, which combined the aggregate demand equation (1) with the money market equilibrium condition set out in (3). That was the basic understanding of the Keynesian model as crystallized by John Hicks, Franco Modigliani, and others, in which it was easy to add detail to the demand functions for private-sector consumption, C; for investment, I; for government spending, G; and for net exports. The Keynesian emphasis on aggregate demand and its determinants is one of the basic innovations of the Keynesian revolution, and one that makes it far easier to understand and explain what factors are determining output and employment.

Continuing down the list, on price and wage dynamics, the Phillips curve has flattened somewhat since the 1950s and 1960s.³ Further, the role of expectations of inflation in the Phillips curve has been developed far beyond what was understood when A.W. Phillips--who was a New Zealander, an LSE faculty member, and a statistician and former engineer--discovered what later became the Phillips curve. The difference between the short- and long-run Phillips curves, which is now a staple of textbooks, was developed by Milton Friedman and Edmund Phelps, and the effect of making expectations rational or model consistent was emphasized by Robert Lucas, whose islands model provided an imperfect information reason for a nonvertical short-run Phillips curve. In Okun's law, the Okun coefficient--the coefficient specifying how much a change in the unemployment rate affects output--appears to have declined over time. So has the trend rate of productivity growth, which is a critical determinant of future levels of per capita income.

In (3), the monetary equilibrium condition, the monetary policy decision was typically represented by the money stock at the LSE and perhaps also at the Massachusetts Institute of Technology (MIT) after the Keynesian revolution (after all, "L" represents the liquidity preference function and "M" the supply of money); now the money supply rule is replaced by an interest-rate setting rule, for instance a reaction function of some form, or by a calculated "optimal" policy based on a loss function.

The development of the flexible inflation-targeting approach to monetary policy is one of the major achievements of modern macroeconomics. Flexible inflation targeting allows for flexibility in the speed with which the monetary authority plans on returning to the target inflation rate, and is thereby close to the dual mandate that the law assigns to the Fed.

A great deal of progress has been made in developing the credit and financial intermediation block. As early as the 1960s, each of James Tobin, Milton Friedman, and Karl Brunner and Alan Meltzer wrote out models with more fully explicated financial sectors, based on demand functions for assets other than money. Later the demand functions were often replaced by pricing equations derived from the capital asset pricing model. Researchers at the Fed have been bold enough to add estimated term and risk premiums to the determination of the returns on some assets.⁴ They have concluded, inter alia, that the arguments we used to make about how easy it would be to measure expected inflation if the government would introduce inflation-indexed bonds failed to take into account that returns on bonds are affected by liquidity and risk premiums. This means that one of the major benefits that were expected from the introduction of inflation-indexed bonds (Treasury Inflation-Protected Securities, generally called TIPS), namely that they would provide a quick and reliable measure of inflation expectations, has not been borne out, and that we still have to struggle to get reasonable estimates of expected inflation.

As students, we included NX, net exports, in the aggregate demand equation, but we did not generally solve for the exchange rate, possibly because the exchange rate was typically fixed. Later, in 1976, Rudi Dornbusch inaugurated modern international macroeconomics--and here I'm quoting from a speech by Ken Rogoff--in his famous overshooting model.⁵ As globalization of both goods and asset markets intensified over the next 40 years, the international aspects of trade in goods and assets occupied an increasingly important role in the economies of virtually all countries, not least the United States, and in macroeconomics.

At the LSE, we took a course on the British economy from Frank Paish, whose lectures consisted of a series of charts, accompanied by narrative from the professor. He made a strong impression on me in a lecture in 1963, in which he said, "You see, it (the balance of payments deficit) goes up and it goes down, and it is clear that we are moving toward a balance of payments crisis in 1964." I waited and I watched, and the crisis appeared on schedule, as predicted. But Paish also warned us that forecasting was difficult, and gave us the advice "Never look back at your forecasts--you may lose your nerve." I pass that wisdom on to those of you who need it.

I remember also my excitement at being told by a friend in a more senior class about the existence of econometric models of the entire economy. It was a wonderful moment. I understood that economic policy would from then on be easy: All that was necessary was to feed the data into the model and work out at what level to set the policy parameters. Unfortunately, it hasn't worked out that way. On the use of econometric models, I think often of something Paul Samuelson once said: "I'd rather have Bob Solow's views than the predictions of a model. But I'd rather have Solow with a model than without one."

We learned a lot at the LSE. But wonderful as it was to be in London, and to meet people from all over the world for the first time, and to be able to travel to Europe and even to the Soviet Union with a student group, and to ski for the first time in my life in Austria, it gradually became clear to me that the center of the academic economics profession was not in London or Oxford or Cambridge, but in the United States.

There was then the delicate business of applying to graduate school. There was a strong Chicago tendency among many of the lecturers at the LSE, but I wanted to go to MIT. When asked why, I gave a simple answer: "Samuelson and Solow." Fortunately, I got into MIT and had the opportunity of getting to know Samuelson and Solow and other great professors. And I also met the many outstanding students who were there at the time, among them Robert Merton. I took courses from Samuelson and Solow and other MIT stars, and I wrote my thesis under the guidance of Paul Samuelson and Frank Fisher. From there, my first job was at the University of Chicago--and I understood that I was very lucky to have been able to learn from the great economists at both MIT and Chicago. Among the many things I learned at Chicago was a Milton Friedman saying: "Man may not be rational, but he's a great rationalizer," which is a quote that often comes to mind when listening to stock market analysts.

After four years at Chicago, I returned to the MIT Department of Economics, and thought that I would never leave--even more so when MIT succeeded in persuading Rudi Dornbusch, whom I had met when he was a student at Chicago, to move to MIT--thus giving him too the benefit of having learned his economics at both Chicago and MIT, and giving MIT the pleasure and benefit of having added a superb economist and human being to the collection of such people already present.

MIT was still heavily involved in developing growth theory at the time I was a Ph.D. student there, from 1966 to 1969. We students were made aware of Kaldor's stylized facts about the process of growth, presented in his 1957 article "A Model of Economic Growth." They were:

1. The shares of national income received by labor and capital are roughly constant over long periods of time.
2. The rate of growth of the capital stock per worker is roughly constant over long periods of time.
3. The rate of growth of output per worker is roughly constant over long periods of time.
4. The capital/output ratio is roughly constant over long periods of time.
5. The rate of return on investment is roughly constant over long periods of time.
6. The real wage grows over time.

Well, that was then, and many of the problems we face in our economy now relate to the changes in the stylized facts about the behavior of the economy: Every one of Kaldor's stylized facts is no longer true, and unfortunately the changes are mostly in a direction that complicates the formulation of economic policy.⁶

While the basic approach outlined so far remains valid, and can be used to address many macroeconomic policy issues, I would like briefly to take up several topics in more detail. Some of them are issues that have remained central to the macroeconomic agenda over the past 50 years, some have to my regret fallen off the agenda, and others are new to the agenda.

1. Inflation and unemployment: Estimated Phillips curves appear to be flatter than they were estimated to be many years ago--in terms of the textbooks, Phillips curves appear to be closer to what used to be called the Keynesian case (flat Phillips curve) than to the classical case (vertical Phillips curve). Since the U.S. economy is now below our 2 percent inflation target, and since unemployment is in the vicinity of full employment, it is sometimes argued that the link between unemployment and inflation must have been broken. I don't believe that. Rather the link has never been very strong, but it exists, and we may well at present be seeing the first stirrings of an increase in the inflation rate--something that we would like to happen.
2. Productivity and growth: The rate of productivity growth in the United States and in much of the world has fallen dramatically in the past 20 years. The table shows calculated rates of annual productivity growth for the United States over three periods: 1952 to 1973; 1974 to 2007; and the most recent period, 2008 to 2015. After having been 3 percent and 2.1 percent in the first two periods, the annual rate of productivity growth has fallen to 1.2 percent in the period since the start of the global financial crisis.

   The right guide to thinking in this case is given by a famous Herbert Stein line: "The difference between a growth rate of 1 percent and 2 percent is 100 percent." Why? Productivity growth is a major determinant of long-term growth. At a 1 percent growth rate, it takes income 70 years to double. At a 2 percent growth rate, it takes 35 years to double. That is to say, that with a growth rate of 1 percent per capita, it takes two generations for per capita income to double; at a 2 percent per capita growth rate, it takes one generation for per capita income to double. That is a massive difference, one that would very likely have severe consequences for the national mood, and possibly for economic policy. That is to say, there are few issues more important for the future of our economy, and those of every other country, than the rate of productivity growth.

   At this stage, we simply do not know what will happen to productivity growth. Robert Gordon of Northwestern University has just published an extremely interesting and pessimistic book that argues we will have to accept the fact that productivity will not grow in future at anything like the rates of the period before 1973. Others look around and see impressive changes in technology and cannot believe that productivity growth will not move back closer to the higher levels of yesteryear.⁷ A great deal of work is taking place to evaluate the data, but so far there is little evidence that data difficulties account for a significant part of the decline in productivity growth as calculated by the Bureau of Labor Statistics.⁸

3. The ZLB and the effectiveness of monetary policy: From December 2008 to December 2015, the federal funds rate target set by the Fed was a range of 0 to 1/4 percent, a range of rates that was described as the ZLB (zero lower bound).⁹ Between December 2008 and December 2014, the Fed engaged in QE--quantitative easing--through a variety of programs. Empirical work done at the Fed and elsewhere suggests that QE worked in the sense that it reduced interest rates other than the federal funds rate, and particularly seems to have succeeded in driving down longer-term rates, which are the rates most relevant to spending decisions.

   Critics have argued that QE has gradually become less effective over the years, and should no longer be used. It is extremely difficult to appraise the effectiveness of a program all of whose parameters have been announced at the beginning of the program. But I regard it as significant with respect to the effectiveness of QE that the taper tantrum in 2013, apparently caused by a belief that the Fed was going to wind down its purchases sooner than expected, had a major effect on interest rates.

   More recently, critics have argued that QE, together with negative interest rates, is no longer effective in either Japan or in the euro zone. That case has not yet been empirically established, and I believe that central banks still have the capacity through QE and other measures to run expansionary monetary policies, even at the zero lower bound.

4. The monetary-fiscal policy mix: There was once a great deal of work on the optimal monetary-fiscal policy mix. The topic was interesting and the analysis persuasive. Nonetheless the subject seems to be disappearing from the public dialogue; perhaps in ascendance is the notion that--except in extremis, as in 2009--activist fiscal policy should not be used at all. Certainly, it is easier for a central bank to change its policies than for a Treasury or Finance Ministry to do so, but it remains a pity that the fiscal lever seems to have been disabled.
5. The financial sector: Carmen Reinhart and Ken Rogoff's book, This Time Is Different, must have been written largely before the start of the great financial crisis. I find their evidence that a recession accompanied by a financial crisis is likely to be much more serious than an ordinary recession persuasive, but the point remains contentious. Even in the case of the Great Recession, it is possible that the U.S. recession got a second wind when the euro-zone crisis worsened in 2011. But no one should forget the immensity of the financial crisis that the U.S. economy and the world went through following the bankruptcy of Lehman Brothers--and no one should forget that such things could happen again.
   
   The subsequent tightening of the financial regulatory system under the Dodd-Frank Act was essential, and the complaints about excessive regulation and excessive demands for banks to hold capital betray at best a very short memory. We, the official sector and particularly the regulatory authorities, do have an obligation to try to minimize the regulatory and other burdens placed on the private sector by the official sector--but we have a no less important obligation to try to prevent another financial crisis. And we should also remember that the shadow banking system played an important role in the propagation of the financial crisis, and endeavor to reduce the riskiness of that system.
6. The economy and the price of oil: For some time, at least since the United States became an oil importer, it has been believed that a low price of oil is good for the economy. So when the price of oil began its descent below $100 a barrel, we kept looking for an oil-price-cut dividend. But that dividend has been hard to discern in the macroeconomic data. Part of the reason is that as a result of the rapid expansion of the production of oil from shale, total U.S. oil production had risen rapidly, and so a larger part of the economy was adversely affected by the decline in the price of oil. Another part is that investment in the equipment and structures needed for shale oil production had become an important component of aggregate U.S. investment, and that component began a rapid decline. For these reasons, although the United States has remained an oil importer, the decrease in the world price of oil had a mixed effect on U.S. gross domestic product. There is reason to believe that when the price of oil stabilizes, and U.S. shale oil production reaches its new equilibrium, the overall effect of the decline in the price of oil will be seen to have had a positive effect on aggregate demand in the United States, since lower energy prices are providing a noticeable boost to the real incomes of households.
7. Secular stagnation: During World War II in the United States, many economists feared that at the end of the war, the economy would return to high pre-war levels of unemployment--because with the end of the war, demobilization, and the massive reduction that would take place in the defense budget, there would not be enough demand to maintain full employment.

   Thus was born or renewed the concept of secular stagnation--the view that the economy could find itself permanently in a situation of low demand, less than full employment, and low growth.¹⁰ That is not what happened after World War II, and the thought of secular stagnation was correspondingly laid aside, in part because of the growing confidence that intelligent economic policies--fiscal and monetary--could be relied on to help keep the economy at full employment with a reasonable growth rate.

   Recently, Larry Summers has forcefully restated the secular stagnation hypothesis, and argued that it accounts for the current slowness of economic growth in the United States and the rest of the industrialized world. The theoretical case for secular stagnation in the sense of a shortage of demand is tied to the question of the level of the interest rate that would be needed to generate a situation of full employment. If the equilibrium interest rate is negative, or very small, the economy is likely to find itself growing slowly, and frequently encountering the zero lower bound on the interest rate.

   Research has shown a declining trend in estimates of the equilibrium interest rate. That finding has become more firmly established since the start of the Great Recession and the global financial crisis.¹¹ Moreover, the level of the equilibrium interest rate seems likely to rise only gradually to a longer-run level that would still be quite low by historical standards.

   What factors determine the equilibrium interest rate? Fundamentally, the balance of saving and investment demands. Several trends have been cited as possible factors contributing to a decline in the long-run equilibrium real rate. One likely factor is persistent weakness in aggregate demand. Among the many reasons for that, as Larry Summers has noted, is that the amount of physical capital that the revolutionary information technology firms with high stock market valuations have needed is remarkably small. The slowdown of productivity growth, which as already mentioned has been a prominent and deeply concerning feature of the past six years, is another important factor.¹² Others have pointed to demographic trends resulting in there being a larger share of the population in age cohorts with high saving rates.¹³ Some have also pointed to high saving rates in many emerging market countries, coupled with a lack of suitable domestic investment opportunities in those countries, as putting downward pressure on rates in advanced economies--the global savings glut hypothesis advanced by Ben Bernanke and others at the Fed about a decade ago.¹⁴

   Whatever the cause, other things being equal, a lower level of the long-run equilibrium real rate suggests that the frequency and duration of future episodes in which monetary policy is constrained by the ZLB will be higher than in the past. Prior to the crisis, some research suggested that such episodes were likely to be relatively infrequent and generally short lived.¹⁵ The past several years certainly require us to reconsider that basic assumption. Moreover, recent experience in the United States and other countries has taught us that conducting monetary policy at the effective lower bound is challenging.¹⁶ And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful and effective, all central banks would prefer a situation with positive interest rates, restoring their ability to use the more traditional interest rate tool of monetary policy.¹⁷

   The answer to the question "Will the equilibrium interest rate remain at today's low levels permanently?" is also that we do not know. Many of the factors that determine the equilibrium interest rate, particularly productivity growth, are extremely difficult to forecast. At present, it looks likely that the equilibrium interest rate will remain low for the policy-relevant future, but there have in the past been both long swings and short-term changes in what can be thought of as equilibrium real rates.

   Eventually, history will give us the answer. But it is critical to emphasize that history's answer will depend also on future policies, monetary and other, notably including fiscal policy.

Concluding Remarks
Well, are the answers all different than they were 50 years ago? No. The basic framework we learned a half-century ago remains extremely useful. But also yes: Some of the answers are different because they were not on previous exams because the problems they deal with were not evident fifty years ago. So the advice to potential policymakers is simple: Learn as much as you can, for most of it will come in useful at some stage of your career; but never forget that identifying what is happening in the economy is essential to your ability to do your job, and for that you need to keep your eyes, your ears, and your mind open, and with regard to your mouth--to use it with caution.

Many thanks again for this award and this opportunity to speak with you.

References
Bernanke, Ben S. (2005). "The Global Saving Glut and the U.S. Current Account Deficit," speech delivered at the Homer Jones Lecture, St. Louis, April 14.

Blanchard, Olivier (2014). "Where Danger Lurks: The Recent Financial Crisis Has Taught Us to Pay Attention to Dark Corners, Where the Economy Can Malfunction Badly," Finance and Development, vol. 51 (September), pp. 28-31.

-------- (2016). "The U.S. Phillips Curve: Back to the 60s? (PDF)" Policy Brief 16-1. Washington: Peterson Institute for International Economics, January.

Blanchard, Olivier, Eugenio Cerutti, and Lawrence Summers (2015). "Inflation and Activity--Two Explorations and Their Monetary Policy Implications (PDF)," IMF Working Paper WP/15/230. Washington: International Monetary Fund, November.

Blanchard, Olivier, and John Simon (2001). "The Long and Large Decline in U.S. Output Volatility (PDF)," Brookings Papers on Economic Activity, 1, pp. 135-74.

Brunner, Karl, and Allan H. Meltzer (1972). "Money, Debt, and Economic Activity," Journal of Political Economy, vol. 80 (September-October), pp.951-77.

Byrne, David M., John G. Fernald, and Marshall Reinsdorf (forthcoming). "Does the United States Have a Productivity Problem or a Measurement Problem?" Brookings Papers on Economic Activity.

Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas (2008). "An Equilibrium Model of 'Global Imbalances' and Low Interest Rates," American Economic Review, vol. 98 (1), pp. 358-93.

Daly, Mary C., John G. Fernald, Òscar Jordà, and Fernanda Nechio (2014). "Output and Unemployment Dynamics (PDF)," Working Paper Series 2013-32. San Francisco: Federal Reserve Bank of San Francisco, November.

-------- (2014). "Interpreting Deviations from Okun's Law," FRBSF Economic Letter 2014-12. San Francisco: Federal Reserve Bank of San Francisco.

D'Amico, Stefania, Don H. Kim, and Min Wei (2014). "Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices (PDF)," Finance and Economics Discussion Series 2014-24. Washington: Board of Governors of the Federal Reserve System, January.

Dornbusch, Rudiger (1976). "Expectations and Exchange Rate Dynamics," Journal of Political Economy, vol. 84 (December), pp. 1161-76.

Dornbusch, Rudiger, Stanley Fischer, and Richard Startz (2014). Macroeconomics, 12th ed. New York: McGraw-Hill Education.

Fischer, Stanley (forthcoming). "Monetary Policy, Financial Stability, and the Zero Lower Bound," American Economic Review (Papers and Proceedings).

Friedman, Milton (1968). "The Role of Monetary Policy," American Economic Review, vol. 58 (March), pp. 1-17.

Gordon, Robert J. (2014). "The Demise of U.S. Economic Growth: Restatement, Rebuttal, and Reflections," NBER Working Paper Series 19895. Cambridge, Mass.: National Bureau of Economic Research, February.

-------- (2016). The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War. Princeton, N.J.: Princeton University Press.

Hall, Robert E. (2014). "Quantifying the Lasting Harm to the U.S. Economy from the Financial Crisis," in Jonathan Parker and Michael Woodford, eds., NBER Macroeconomics Annual 2014, vol. 29. Chicago: University of Chicago Press.

Hamilton, James D., Ethan S. Harris, Jan Hatzius, and Kenneth D. West (2015). "The Equilibrium Real Funds Rate: Past, Present and Future," NBER Working Paper Series 21476. Cambridge, Mass.: National Bureau of Economic Research, August.

Hicks, John R. (1937). "Mr. Keynes and the 'Classics': A Suggested Interpretation," Econometrica, vol. 5 (April), pp. 147-59.

Johannsen, Benjamin K., and Elmar Mertens (2016). "The Expected Real Interest Rate in the Long Run: Time Series Evidence with the Effective Lower Bound," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, February 9.

Jones, Charles I., and Paul M. Romer (2010). "The New Kaldor Facts: Ideas, Institutions, Population, and Human Capital," American Economic Journal: Macroeconomics, vol. 2 (January), pp. 224-45.

Kaldor, Nicholas (1957). "A Model of Economic Growth," Economic Journal, vol. 67 (December), pp. 591-624.

Keynes, John Maynard (1936). The General Theory of Employment, Interest and Money. London: Macmillan.

Kiley, Michael T. (2015). "What Can the Data Tell Us about the Equilibrium Real Interest Rate? (PDF)" Finance and Economics Discussion Series 2015-077. Washington: Board of Governors of the Federal Reserve System, August.

Knotek, Edward S., II (2007). "How Useful Is Okun's Law? (PDF)" Federal Reserve Bank of Kansas City, Economic Review, Fourth Quarter, pp. 73-103.

Laubach, Thomas, and John C. Williams (2003). "Measuring the Natural Rate of Interest," Review of Economics and Statistics, vol. 85 (November), pp. 1063-70.

Lucas, Robert E., Jr. (1972). "Expectations and the Neutrality of Money," Journal of Economic Theory, vol. 4 (April), pp. 103-24.

Mendoza, Enrique G., Vincenzo Quadrini, and José-Víctor Ríos-Rull (2009). "Financial Integration, Financial Development, and Global Imbalances," Journal of Political Economy, vol. 117 (3), pp. 371-416.

Modigliani, Franco (1944). "Liquidity Preference and the Theory of Interest and Money," Econometrica, vol. 12 (January), pp. 45-88.

Mokyr, Joel, Chris Vickers, and Nicolas L. Ziebarth (2015). "The History of Techonological Anxiety and the Future of Economic Growth: Is This Time Different?" Journal of Economic Perspectives, vol. 29 (Summer), pp. 31-50.

Obstfeld, Maurice, and Kenneth Rogoff (1996). Foundations of International Macroeconomics. Cambridge, Mass.: MIT Press.

Okun, Arthur M. (1962). "Potential GNP: Its Measurement and Significance," Proceedings of the Business and Economics Statistics Section of the American Statistical Association, pp. 98-104.

Phelps, Edmund S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time," Economica, vol. 34 (August), pp. 254-81.

Reifschneider, David, and John C. Williams (2000). "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit, and Banking, vol. 32 (November), pp. 936-66.

Reinhart, Carmen M., and Kenneth S. Rogoff (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton, N.J.: Princeton University Press.

Rogoff, Kenneth (2001). "Dornbusch's Overshooting Model after Twenty-Five Years (PDF)," speech delivered at the Mundell-Fleming Lecture, Second Annual Research Conference, International Monetary Fund, Washington, November 30 (revised January 22, 2002).

Solow, Robert M. (2004). "Introduction: The Tobin Approach to Monetary Economics," Journal of Money, Credit, and Banking, vol. 36 (August), pp. 657-63.

Stock, James H., and Mark W. Watson (2003). "Has the Business Cycle Changed and Why?" NBER Macroeconomics Annual 2002, vol. 17 (January).

Tobin, James (1969). "A General Equilibrium Approach to Monetary Theory (PDF)," Journal of Money, Credit, and Banking, vol. 1 (February), pp. 15-29.

U.S. Executive Office of the President, Council of Economic Advisors (2015). Long-Term Interest Rates: A Survey (PDF). Washington: EOP.

Williams, John C. (2013). "A Defense of Moderation in Monetary Policy (PDF)," Working Paper Series 2013-15. San Francisco: Federal Reserve Bank of San Francisco, July.

Woodford, Michael (2010). "Financial Intermediation and Macroeconomic Analysis," Journal of Economic Perspectives, vol. 24 (Fall), pp. 21-44.

---

1. I am grateful to David Lopez-Salido, Andrea Ajello, Elmar Mertens, Stacey Tevlin, and Bill English of the Federal Reserve Board for their assistance. Views expressed are mine, and are not necessarily those of the Federal Reserve Board or the Federal Open Market Committee.

2. A fuller description of the equations is contained in the appendix.

3. See Blanchard (2016).

4. See D'Amico, Kim, and Wei (2014).

5. See Dornbusch (1976) and Rogoff (2001).

6. See Jones and Romer (2010).

7. See, for instance, Mokyr, Vickers, and Ziebarth (2015).

8. See Byrne, Fernald, and Reinsdorf (forthcoming).

9. Inside the Fed, the range of 0 to 1/4 percent is generally called the ELB, the effective lower bound.

10. I am distinguishing in this section between secular stagnation as being caused by a deficiency of aggregate demand and another view, that output growth will be very slow in future because productivity growth will be very low. The view that future productivity growth will be very low has already been discussed, with the conclusion that we do not have a good basis for predictions of its future level, and that we simply do not know whether future productivity growth will be extremely low or higher than it has been recently. There is no shortage of views on this issue among economists, but the views to some extent appear to depend on whether the economist making the prediction is an optimist or a pessimist.

11. This research includes recent work by Johannsen and Mertens (2015) and Kiley (2015) that uses extensions of the original Laubach and Williams (2003) framework. An international perspective on medium-to-long-run real interest rates is provided by U.S. Executive Office of the President (2015). Reinhart and Rogoff (2009) and Hall (2014) discuss the long-lived effects of financial crises on economic performance. See also Hamilton and others (2015). I have, in addition, drawn on Fischer (forthcoming).

12. It is also a major factor explaining the phenomenon of the economy's impressive performance on the jobs front during a period of historically slow growth.

13. See, for instance, Gordon (2014, 2016).

14. See Bernanke (2005). See also the recent work by Caballero, Farhi, and Gourinchas (2008); and Mendoza, Quadrini, and Rios-Rull (2009).

15. See, for instance, Reifschneider and Williams (2000), Blanchard and Simon (2001), and Stock and Watson (2003).

16. For a discussion of various issues reviewed by the Federal Open Market Committee in late 2008 and 2009 regarding the complications of unconventional monetary policy at the ZLB, see the set of staff memos on the Board's website.

17. See Williams (2013).

Toward a Better Monetary Policy Reaction Function

Narayana Kocherlakota:

Monetary Policy Renormalization:  ... Point 3: Toward a Better Reaction Function I’ve argued that, in November 2009, the FOMC was aiming for a slow recovery in both prices and employment. I’ve argued too that the Committee’s desire for a slow recovery was consistent with its pre-2008 reaction function, which sought to constrain the variability of short-term interest rates. I now turn to the question of how the FOMC could change its “normal” policy reaction function so as to engender a better response to severe adverse shocks.

To be clear, there have been many prior suggestions about how to arrive at a better framework. Some observers have suggested that the FOMC should increase the inflation target, so as to have more policy space to deal with adverse demand shocks. Some observers have suggested that the FOMC should target the price level rather than the inflation rate. Still others have suggested that the FOMC should target the level of nominal income.

I see merit in all of these suggestions, and I welcome explorations of their consequences. But they represent large changes in the FOMC’s long-run goals. I will instead recommend a more minimal change in terms of the FOMC’s strategy—that is, how it seeks to pursue its current long-run goals. My recommendation is that the FOMC should adopt a policy framework that puts considerably more emphasis on returning the economy to its dual mandate objectives over the medium term. Such a framework would immediately imply that the FOMC should use a monetary policy reaction function that is a lot more responsive to the Committee’s best medium-term projections of inflation and output gaps.
What would be the benefits of this change in the FOMC’s strategic framework? I see two clear benefits. First, the FOMC’s choices would systematically return both inflation and output to desired levels more rapidly. There would be less persistence and less volatility in both inflation and output gaps. Second, the credibility of the FOMC’s inflation target would be enhanced. As noted earlier, in November 2009, the staff projected that, if the FOMC used the Taylor Rule after liftoff, inflation would remain at 1.6 percent or below for the next five years. This kind of outcome creates large downside risk to the credibility of the inflation target.

Those are the benefits: less variance in macroeconomic variables and enhanced credibility of the FOMC’s long-run inflation target. What would be the costs? The key cost is that, of course, the fed funds rate would be more variable around its long-run level. I have two comments about this putative cost. First, I don’t know of models in which such a cost is grounded in traditional welfare economics.¹⁰ The real interest rate is a key intertemporal price, and it may need to vary a lot to effect a desirable allocation of resources. According to models that are currently available, it would be welfare-reducing to smooth the fluctuations of this important price.

Second, and perhaps relatedly, my reading of the Federal Reserve Act is that Congress has not mandated that the FOMC seek to constrain the variability of its policy instruments. Congress has mandated that the Committee adjust its policy instruments as needed so as to achieve its macroeconomic objectives.¹¹

To summarize my third and final point: The FOMC should strongly consider lowering its implicit penalty on interest rate variability relative to what was being imposed before the crisis. Doing so would lead the Committee to use a monetary policy reaction function that puts more weight on its forecasts of inflation and output gaps. Such a reaction function would automatically engender a more appropriate monetary policy response to severe downturns in inflation and employment such as those experienced during the Great Recession.

Conclusions

The theme of this speech is that the FOMC’s thinking about appropriate monetary policy in extraordinary times like late 2009 is heavily influenced by its policy framework during normal times. It should choose its new “normal” policy framework with this in mind. I have argued that the pre-2008 framework led the Committee to aim for a relatively slow recovery in inflation and employment in the wake of the Great Recession. I’ve recommended that, going forward, the Committee should use a reaction function that would be considerably more responsive to its best available forecasts of inflation and output gaps.

The U.S. House recently passed a measure, the Fed Oversight Reform and Modernization Act, that would enshrine the Taylor Rule as a key benchmark for monetary policy. Federal Reserve Chair Janet Yellen recently wrote in a letter¹² to House leaders that the bill “would severely impair the Federal Reserve's ability to carry out its congressional mandate to foster maximum employment and stable prices and would undermine ability to implement policies that are in the best interest of American businesses and consumers.”  

My argument today gives a concrete example of Chair Yellen’s criticism. The FOMC did treat the Taylor Rule as a key benchmark for monetary policy during the early part of the recovery from the Great Recession. By doing so, we were systematically led to make choices that were designed to keep both employment and prices needlessly low for years.

Ultimately, if this legislation were to become law, it would force the Federal Reserve into the same kinds of choices in the wake of future adverse shocks.

'U.S. Inflation Developments'

[A speech by Stanley Fischer at Jackson Hole turned into a pretend interview]

Hello, and thank you for talking with us.

 Let me start by asking if you feel like it gives the Fed a bad image to have a conference in an elite place like Jackson Hole. Why not have the conference in, say, a disadvantaged area to send the signal that you care about these problems, to provide some stimulus to the area, etc.?

I am delighted to be here in Jackson Hole in the company of such distinguished panelists and such a distinguished group of participants.

Okay then. Let me start be asking about your view of the economy. How close are we to a full recovery?:

Although the economy has continued to recover and the labor market is approaching our maximum employment objective, inflation has been persistently below 2 percent. That has been especially true recently, as the drop in oil prices over the past year, on the order of about 60 percent, has led directly to lower inflation as it feeds through to lower prices of gasoline and other energy items. As a result, 12-month changes in the overall personal consumption expenditure (PCE) price index have recently been only a little above zero (chart 1).

Why are you telling us about headline inflation? What about core inflation? Isn't that what the Fed watches?

...measures of core inflation, which are intended to help us look through such transitory price movements, have also been relatively low (return to chart 1). The PCE index excluding food and energy is up 1.2 percent over the past year. The Dallas Fed's trimmed mean measure of the PCE price index is higher, at 1.6 percent, but still somewhat below our 2 percent objective. Moreover, these measures of core inflation have been persistently below 2 percent throughout the economic recovery. That said, as with total inflation, core inflation can be somewhat variable, especially at frequencies higher than 12-month changes. Moreover, note that core inflation does not entirely "exclude" food and energy, because changes in energy prices affect firms' costs and so can pass into prices of non-energy items.

So are you saying you don't believe the numbers? Why bring up that core inflation is highly variable unless you are trying to de-emphasize this evidence? In any case, isn't there reason to believe these numbers are true, i.e. doesn't the slack in the labor market imply low inflation?

Of course, ongoing economic slack is one reason core inflation has been low. Although the economy has made great progress, we started seven years ago from an unemployment rate of 10 percent, which guaranteed a lengthy period of high unemployment. Even so, with inflation expectations apparently stable, we would have expected the gradual reduction of slack to be associated with less downward price pressure. All else equal, we might therefore have expected both headline and core inflation to be moving up more noticeably toward our 2 percent objective. Yet, we have seen no clear evidence of core inflation moving higher over the past few years. This fact helps drive home an important point: While much evidence points to at least some ongoing role for slack in helping to explain movements in inflation, this influence is typically estimated to be modest in magnitude, and can easily be masked by other factors.

If that's true, if the decline in the slack in the labor market does not translate into a notable change in inflation, why is the Fed so anxious to raise rates based upon the notion that the labor market has almost normalized? Is there more to it than just the labor market?

...core inflation can to some extent be influenced by oil prices. However, a larger effect comes from changes in the exchange value of the dollar, and the rise in the dollar over the past year is an important reason inflation has remained low (chart 4). A higher value of the dollar passes through to lower import prices, which hold down U.S. inflation both because imports make up part of final consumption, and because lower prices for imported components hold down business costs more generally. In addition, a rise in the dollar restrains the growth of aggregate demand and overall economic activity, and so has some effect on inflation through that more indirect channel.

That argues against a rate increase, not for it. Anyway, I interrupted, please continue.

Commodity prices other than oil are also of relevance for inflation in the United States. Prices of metals and other industrial commodities, and agricultural products, are affected to a considerable extent by developments outside the United States, and the softness we've seen in these commodity prices, has in part reflected a slowing of demand from China and elsewhere. These prices likely have also been a factor in holding down inflation in the United States.

So you must believe that all of these forces holding down inflation (many of which are stripped out by core inflation measures, which are also low) that these factors are easing, and hence a spike in inflation is ahead?

The dynamics with which all these factors affect inflation depend crucially on the behavior of inflation expectations. One striking feature of the economic environment is that longer-term inflation expectations in the United States appear to have remained generally stable since the late 1990s (chart 6). ... Expectations that are not stable, but instead follow actual inflation up or down, would allow inflation to drift persistently. In the recent period, movements in inflation have tended to be transitory.

Let's see, lots of factors holding down inflation, longer-term inflation expectations have been stable throughout the recession and recovery, remarkably so, yet the Fed still thinks a rate raise ought to come fairly soon?

We should however be cautious in our assessment that inflation expectations are remaining stable. One reason is that measures of inflation compensation in the market for Treasury securities have moved down somewhat since last summer (chart 7). But these movements can be hard to interpret, as at times they may reflect factors other than inflation expectations, such as changes in demand for the unparalleled liquidity of nominal Treasury securities.

I have to be honest. That sounds like the Fed is really reaching to find a reason to justify worries about inflation and a rate increase. Let me ask this a different way. In the Press Release for the July meeting of the FOMC, the committee said it can be " reasonably confident that inflation will move back to its 2 percent objective over the medium term." Can you explain this please? Why are you "reasonably confident" in light of recent history?

Can the Committee be "reasonably confident that inflation will move back to its 2 percent objective over the medium term"? As I have discussed, given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further. While some effects of the rise in the dollar may be spread over time, some of the effects on inflation are likely already starting to fade. The same is true for last year's sharp fall in oil prices, though the further declines we have seen this summer have yet to fully show through to the consumer level. And slack in the labor market has continued to diminish, so the downward pressure on inflation from that channel should be diminishing as well.

Yet when these forces were absent -- they weren't there throughout the crisis -- inflation was still stable. But this time will be different? I guess falling slack in the labor market will make all the difference? More on labor markets in a moment, but let me ask if you have more to say about inflation expectations first.

...with regard to expectations of inflation, it is possible to consult the results of the SEP, the Survey of Economic Projections, which FOMC participants complete shortly before the March, June, September, and December meetings. In the June SEP, the central tendency of FOMC participants' projections for core PCE inflation was 1.3 percent to 1.4 percent this year, 1.6 percent to 1.9 percent next year, and 1.9 percent to 2.0 percent in 2017. There will be a new SEP for the forthcoming September meeting of the FOMC.

Reflecting all these factors, the Committee has indicated in its post-meeting statements that it expects inflation to return to 2 percent. With regard to our degree of confidence in this expectation, we will need to consider all the available information and assess its implications for the economic outlook before coming to a judgment.

You will need to consider all the available information, I agree wholeheartedly with that. I just hope that information includes how poor forecasts like those just cited have been in the past, and the Fed's own eagerness to see "green shoots" again and again, far before it was time for such declarations.

What might deter the Fed from it's intention to raise rates sooner rather than later?

Of course, the FOMC's monetary policy decision is not a mechanical one, based purely on the set of numbers reported in the payroll survey and in our judgment on the degree of confidence members of the committee have about future inflation. We are interested also in aspects of the labor market beyond the simple U-3 measure of unemployment, including for example the rates of unemployment of older workers and of those working part-time for economic reasons; we are interested also in the participation rate. And in the case of the inflation rate we look beyond the rate of increase of PCE prices and define the concept of the core rate of inflation.

I find these kinds of statement difficult to square with the statement that labor markets are almost back to normal. Anyway, what, in particular, will you look at?

While thinking of different aspects of unemployment, we are concerned mainly with trying to find the right measure of the difficulties caused to current and potential participants in the labor force by their unemployment. In the case of the core rate of inflation, we are mainly looking for a good indicator of future inflation, and for better indicators than we have at present.

How do recent events in China change the outlook for policy?

In making our monetary policy decisions, we are interested more in where the U.S. economy is heading than in knowing whence it has come. That is why we need to consider the overall state of the U.S. economy as well as the influence of foreign economies on the U.S. economy as we reach our judgment on whether and how to change monetary policy. That is why we follow economic developments in the rest of the world as well as the United States in reaching our interest rate decisions. At this moment, we are following developments in the Chinese economy and their actual and potential effects on other economies even more closely than usual.

I know you won't answer this directly, but let me try anyway. When will rates go up?

The Fed has, appropriately, responded to the weak economy and low inflation in recent years by taking a highly accommodative policy stance. By committing to foster the movement of inflation toward our 2 percent objective, we are enhancing the credibility of monetary policy and supporting the continued stability of inflation expectations. To do what monetary policy can do towards meeting our goals of maximum employment and price stability, and to ensure that these goals will continue to be met as we move ahead, we will most likely need to proceed cautiously in normalizing the stance of monetary policy. For the purpose of meeting our goals, the entire path of interest rates matters more than the particular timing of the first increase.

As expected, that was pretty boilerplate. When rates do go up, how fast will they rise?

With inflation low, we can probably remove accommodation at a gradual pace. Yet, because monetary policy influences real activity with a substantial lag, we should not wait until inflation is back to 2 percent to begin tightening. Should we judge at some point in time that the economy is threatening to overheat, we will have to move appropriately rapidly to deal with that threat. The same is true should the economy unexpectedly weaken.

The Fed has said again and again that it's 2 percent inflation target is symmetric with respect to errors, i.e. it will get no more worried or upset about, say, a .5 percent overshoot of the target than it will an undershoot of the same magnitude (2.5 percent versus 1.5 percent). However, many of us suspect that the 2 percent target is actually a ceiling, not a central tendency, or that at the very least the errors are not treated symmetrically, and statements such as this do nothing to change that view.

I have quite a few more questions, and I wish we had time to hear your response to the charge that the 2 percent target is functionally a ceiling, but I know you are out of time and need to go, so let me just thank you for talking with us today. Thank you.

'Perspectives on Inequality and Opportunity'

Janet Yellen at the Conference on Economic Opportunity and Inequality, FRB Boston, Boston:

Perspectives on Inequality and Opportunity from the Survey of Consumer Finances, by Janet Yellen, Chair, FRB: The distribution of income and wealth in the United States has been widening more or less steadily for several decades, to a greater extent than in most advanced countries.¹ This trend paused during the Great Recession because of larger wealth losses for those at the top of the distribution and because increased safety-net spending helped offset some income losses for those below the top. But widening inequality resumed in the recovery, as the stock market rebounded, wage growth and the healing of the labor market have been slow, and the increase in home prices has not fully restored the housing wealth lost by the large majority of households for which it is their primary asset.

The extent of and continuing increase in inequality in the United States greatly concern me. The past several decades have seen the most sustained rise in inequality since the 19th century after more than 40 years of narrowing inequality following the Great Depression. By some estimates, income and wealth inequality are near their highest levels in the past hundred years, much higher than the average during that time span and probably higher than for much of American history before then.² It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority. I think it is appropriate to ask whether this trend is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity.

Some degree of inequality in income and wealth, of course, would occur even with completely equal opportunity because variations in effort, skill, and luck will produce variations in outcomes. Indeed, some variation in outcomes arguably contributes to economic growth because it creates incentives to work hard, get an education, save, invest, and undertake risk. However, to the extent that opportunity itself is enhanced by access to economic resources, inequality of outcomes can exacerbate inequality of opportunity, thereby perpetuating a trend of increasing inequality. Such a link is suggested by the "Great Gatsby Curve," the finding that, among advanced economies, greater income inequality is associated with diminished intergenerational mobility.³ In such circumstances, society faces difficult questions of how best to fairly and justly promote equal opportunity. My purpose today is not to provide answers to these contentious questions, but rather to provide a factual basis for further discussion. I am pleased that this conference will focus on equality of economic opportunity and on ways to better promote it.

In my remarks, I will review trends in income and wealth inequality over the past several decades, then identify and discuss four sources of economic opportunity in America--think of them as "building blocks" for the gains in income and wealth that most Americans hope are within reach of those who strive for them. The first two are widely recognized as important sources of opportunity: resources available for children and affordable higher education. The second two may come as more of a surprise: business ownership and inheritances. Like most sources of wealth, family ownership of businesses and inheritances are concentrated among households at the top of the distribution. But both of these are less concentrated and more broadly distributed than other forms of wealth, and there is some basis for thinking that they may also play a role in providing economic opportunities to a considerable number of families below the top.

In focusing on these four building blocks, I do not mean to suggest that they account for all economic opportunity, but I do believe they are all significant sources of opportunity for individuals and their families to improve their economic circumstances. ...[continue]...

See also Neil Irwin, "What Janet Yellen Said, and Didn’t Say, About Inequality," who says:

If there was any doubt that Janet Yellen would be a different type of Federal Reserve chair, her speech Friday in Boston removed it. ...

Ms. Yellen’s speech is a thorough airing of some of the latest research on how much inequality has widened in recent years and why. ...

It seems like Ms. Yellen offered this speech as a way to use her bully pulpit to cast public attention on an issue she cares about deeply, deliberately avoiding areas where inequality intersects with the policy areas under which she has direct control. And it is true that the future of inequality in the United States is surely shaped more by decisions on the levels of certain taxes and the size of the social welfare state more than by anything that the Fed does.

Perhaps in future appearances, Ms. Yellen will give us a sense not just of what is wrong with inequality, but what it might mean for the policies over which she has some control.

'Persistently Below-Target Inflation Rate is a Signal That the U.S. Economy is Not Taking Advantage of all of its Available Resources'

Narayana Kocherlakota, President of the Minneapolis Fed:

..I’m a member of the Federal Open Market Committee—the FOMC—and, as a monetary policymaker, my discussion will be framed by the goals of monetary policy. Congress has charged the FOMC with making monetary policy so as to promote price stability and maximum employment. I’ll discuss the state of the macroeconomy in terms of these goals.

Let me start with price stability. The FOMC has translated the price stability objective into an inflation rate goal of 2 percent per year. This inflation rate target refers to the personal consumption expenditures, or PCE, price index. ... That rate currently stands at 1.6 percent, which is below the FOMC’s target of 2 percent. In fact, the inflation rate has averaged 1.6 percent since the start of the recession six and a half years ago, and inflation is expected to remain low for some time. For example, the minutes from the June FOMC meeting reveal that the Federal Reserve Board staff outlook is for inflation to remain below 2 percent over the next few years.

In a similar vein, earlier this year, the Congressional Budget Office (CBO) predicted that inflation will not reach 2 percent until 2018—more than 10 years after the beginning of the Great Recession. I agree with this forecast. This means that the FOMC is still a long way from meeting its targeted goal of price stability.

The second FOMC goal is to promote maximum employment. What, then, is the state of U.S. labor markets? The latest unemployment rate was 6.2 percent for July. This number is representative of the significant improvement in labor market conditions that we’ve seen since October 2009, when the unemployment rate was 10 percent. And I expect this number to fall further through the course of this year, to around 5.7 percent. However, this progress in the decline of the unemployment rate masks continued weakness in labor markets.

There are many ways to see this continued weakness. I’ll mention two that I see as especially significant. First, the fraction of people aged 25 to 54—our prime-aged potential workers—who actually have a job is still at a disturbingly low rate. Second, a historically high percentage of workers would like a full-time job, but can only find part-time work. Bottom line: I see labor markets as remaining some way from meeting the FOMC’s goal of full employment.

So I’ve told you that inflation rates will remain low for a number of years and that labor markets are still weak. It is important, I think, to understand the connection between these two phenomena. As I have discussed in greater detail in recent speeches, a persistently below-target inflation rate is a signal that the U.S. economy is not taking advantage of all of its available resources. If demand were sufficiently high to generate 2 percent inflation, the underutilized resources would be put to work. And the most important of those resources is the American people. There are many people in this country who want to work more hours, and our society is deprived of their production. ...

Yellen: The Economic Outlook

This is from Janet Yellen's prepared testimony before the Joint Economic Committee (the actual speech is much longer than this extract):

The Economic Outlook, by Janey Yellen, FRB, May 7, 2014: Chairman Brady, Vice Chair Klobuchar, and other members of the Committee, I appreciate this opportunity to discuss the current economic situation and outlook along with monetary policy before turning to some issues regarding financial stability.

Current Economic Situation and Outlook The economy has continued to recover from the steep recession of 2008 and 2009. Real gross domestic product (GDP) growth stepped up to an average annual rate of about 3-1/4 percent over the second half of last year, a faster pace than in the first half and during the preceding two years. Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.

Conditions in the labor market have continued to improve. ...

While conditions in the labor market have improved appreciably, they are still far from satisfactory. ...

Inflation has been quite low even as the economy has continued to expand. Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable. That said, the Federal Open Market Committee (FOMC) recognizes that inflation persistently below 2 percent--the rate that the Committee judges to be most consistent with its dual mandate--could pose risks to economic performance, and we are monitoring inflation developments closely.

Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent. A faster rate of economic growth this year should be supported by reduced restraint from changes in fiscal policy, gains in household net worth from increases in home prices and equity values, a firming in foreign economic growth, and further improvements in household and business confidence as the economy continues to strengthen. Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment.

As always, considerable uncertainty surrounds this baseline economic outlook. At present, one prominent risk is that adverse developments abroad, such as heightened geopolitical tensions or an intensification of financial stresses in emerging market economies, could undermine confidence in the global economic recovery. Another risk--domestic in origin--is that the recent flattening out in housing activity could prove more protracted than currently expected rather than resuming its earlier pace of recovery. Both of these elements of uncertainty will bear close observation. ...

While we have seen substantial improvements in labor market conditions and the overall economy since the financial crisis and severe recession, we recognize that more must be accomplished. Many Americans who want a job are still unemployed, inflation continues to run below the FOMC's longer-run objective, and work remains to further strengthen our financial system. I will continue to work closely with my colleagues and others to carry out the important mission that the Congress has given the Federal Reserve. ...

Evans on the Outlook for Monetary Policy

Chicago Fed president Charlie Evans on what is likely to happen to the federal funds rate as the unemployment rate crosses the 6.5% thresshold:

Back in December 2012, the FOMC introduced conditional forward guidance by saying it would hold the funds rate at exceptionally low levels at least as long as the unemployment rate remains above 6-1/2 percent and the projection for inflation between one and two years ahead is less than 2-1/2 percent and longer-term inflation expectations remain well anchored. Let me emphasize the “at least.” As we often stated, the 6-1/2 percent unemployment number was a threshold and not a trigger. Crossing 6-1/2 percent would not automatically result in an increase in the funds rate. Exactly when we would begin to raise the funds rate once we hit 6-1/2 percent depends critically on whether we are expecting continued improvements in the labor market and on what the outlook for inflation is relative to our 2 percent target.

When evaluating the situation at our meeting this past December, we reasoned that conditions had evolved in a way that meant we could — and should — provide more specificity on what might happen with the federal funds rate when the economy reached this threshold. Importantly, in my mind, the low readings for inflation by themselves now suggest that it likely will be appropriate to keep the funds rate at its current level for quite some time. So I supported our change in language to say that the federal funds rate likely will remain in its current range “well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.”[2] This elaboration of our forward guidance should more strongly communicate that we are in no hurry to raise rates: We will not prematurely reduce accommodation in an economy with elevated unemployment and very low inflation pressures.

If that's the case, then why taper QE?:

When the Committee met this past December, with the unemployment rate at 7 percent and other labor market indicators showing improvement, we decided that the cumulative improvement to that point met the criteria for first scaling back purchases. This decision does not, however, mean we thought the economy needed less overall policy accommodation. Rather, the Committee agreed it was time to rebalance the mix of monetary policy. Large-scale asset purchases have been effective in stimulating activity, and their effects have shown more through to top-line gross domestic product (GDP) growth now that the most restrictive fiscal influences in the first half of 2013 have waned some. Nevertheless, QE3 is a nontraditional policy instrument. If in fact monetary policy and the recovery are now gaining better traction, it makes sense to rely more on our traditional short-term interest rate policy tool, the federal funds rate. We have a much better understanding of how changes in the funds rate affect the economy than we do of the benefits and potential costs associated with large-scale asset purchases, largely because we simply have more experience with the former policy tool.

In order to clarify that overall monetary policy will remain highly accommodative as long as necessary, we also decided to strengthen the forward guidance in our policy statement concerning the economic conditions likely to prevail when we might eventually first increase the federal funds rate.

Part of the problem is that fiscal policy has been a "powerful headwind":

Theme 1: Fiscal Restraint Has Been a Powerful Headwind

Heightened fiscal austerity has been front page news in 2013. The year began with both tax hikes and automatic spending cuts known as sequestration. The Congressional Budget Office (CBO) estimates that federal fiscal restraint reduced real GDP growth by about 1-1/2 percentage points last year.[3] In other words, to get to 2-1/2 percent real GDP growth, the rest of the economy had to generate 4 percentage points of growth. ...

If we look at the entire 2009 through 2013 period, real GDP increased at an average annual rate of 2.2 percent. However, excluding state, local and federal government purchases, private spending grew at a 3.2 percent pace. This isn’t the stellar rate of growth for private spending that one would hope for given the magnitude of the Great Recession, but it is a much healthier number than the 2.2 percent rate of growth for real GDP: At some level, this reflects how private sector strength supported by monetary policy accommodation offset the contraction in government purchases.

Of course, government restraint has not been the only headwind the economy has faced. The fallout from the financial crisis has been large. ... But the restraint from the federal government sector has been a self-inflicted wound, and it has been unusual relative to other historical episodes.

Let me give you an example. In 1981-82, the economy experienced a severe downturn, but it rebounded rapidly. One reason was that increases in government purchases contributed nearly a percentage point to growth, on average, in 1983 and 1984. Large tax cuts also helped fuel the recovery. Contrast that to the fiscal restraint that we’ve seen recently.

In addition to fiscal policy impetus, the Federal Reserve was able to reduce the federal funds rate as much as was necessary to get growth back on track. With the federal funds rate at nearly 15 percent in 1982, it was possible to drop the rate by 6 percentage points. However, in the current environment, monetary policy has less room to maneuver because short-term interest rates are already pushed to their lowest possible limits. We have had to work harder and turn to unconventional tools to help counteract the fiscal restraint and other forces holding back growth. This leads me to the second theme.

Theme 2: The Zero Lower Bound

Today, the federal funds rate is effectively pushed as low as it can go. It stands near zero and has been at that rate since December 2008. Central bankers refer to this as the zero lower bound. Operating near the zero lower bound has limited the Fed’s ability to use its traditional tools to offset the ferocious impediments to growth that I just outlined. We have tried to overcome this obstacle with nontraditional policies. The main two are the ones I discussed earlier — our large-scale asset purchase programs and, separately, forward guidance regarding the economic conditions under which we would consider to begin to raise rates. ...

By mitigating some of the headwinds I mentioned earlier, LSAPs and forward guidance have helped return the economy to better health. There is still a ways to go. Our two nontraditional policy tools have simply not been strong enough to overcome these headwinds and generate an early 1980s “morning in America” recovery yet.[4] Moreover, inflation remains stubbornly low.

This low inflation environment is the third theme I’d like to cover today. ...

He ends with:

In terms of monetary policy strategy, after four years of weak and inadequate growth with low inflation, we need extraordinary monetary accommodation to finish the task at hand. The public must have confidence in the Fed’s ultimate resolve to successfully address economic challenges. We need to be both bold and committed to following through. ...

We often talk about this in terms of credibility. Credibility means that we are clear about our goals, have the tools to achieve those goals and are committed to using those tools.

We have been clear about our goals. We are dedicated to achieving our statutory dual mandate of maximum employment and price stability. We certainly have turned to unprecedented actions to get the job done — near-zero short-term interest rates; strong forward guidance about keeping rates low for well after the economic recovery strengthens; and large-scale assets purchases that have boosted our balance sheet from about $800 billion to more than $4 trillion. And we must continue to be willing to use these tools to put us on a clear track back to full employment and inflation averaging our 2 percent target.

I'm not sure everyone would agree that tapering is simply a step to "rebalance the mix of monetary policy" rather than a change in overall accommodation.

Economics at the Federal Reserve Banks

Some clues about the recent shakeup in the research Department at the Minneapolis Fed? ("Reserve Banks need a wide range of skills and perspectives to fulfill their public policy missions"). This is Narayana Kocherlakota, president of the Minneapolis Fed:

Economics at the Federal Reserve Banks, by Narayana Kocherlakota - President, Federal Reserve Bank of Minneapolis, Opening Statement—Panel Discussion, American Economic Association Annual Meeting, Philadelphia, Pennsylvania, January 4, 2014: Note ¹ I’d like to use this opportunity to talk about the role of economic research and economists within a Reserve Bank. My main theme is that, to be successful at their host of responsibilities, Reserve Banks need economists with a wide range of perspectives and skills. Conversely, economists in a variety of fields can enjoy fulfilling and successful careers at Reserve Banks. I’ll illustrate my points by using examples from my own institution, the Federal Reserve Bank of Minneapolis.

The views that I express today are my own and not necessarily those of others in the Federal Reserve System, including my colleagues on the Federal Open Market Committee.

My first observation is that, just like economists who work at universities and colleges, many economists within Reserve Banks spend a great deal of time on independent research. Many Reserve Banks—including the Minneapolis Federal Reserve Bank—have found that, especially over the longer term, this self-directed research has the power to create valuable new insights into important public policy questions. For example, back in the 1990s, Harold Cole and Lee Ohanian—then at the Minneapolis Fed—developed an exciting and important new way to think about the slow recovery during the Great Depression.² This work in economic history has turned out to be a valuable resource for many who are thinking about the current slow recovery.

Over the past four decades in Minneapolis, we have found that, to be effective, independent research should follow the usual rules of academic economics. More specifically, economists must be free to pursue any question, use any available tools and arrive at any answer. The quality of those answers is ultimately measured by rigorous academic peer review, not by internal managerial judgment.

So, university and Reserve Bank jobs are not all that different in terms of the role of independent research. What distinguishes academic jobs from Reserve Bank jobs for economists is how they spend their non-research time. Economists with academic jobs spend most of their non-research time teaching. Economists with Reserve Bank jobs spend most of their non-research time supporting public policy work. As I stated at the outset, my main theme today is that public policy work in a Reserve Bank relies on a much wider variety of economic specializations than might be generally appreciated.

I’ll start by talking about the most visible of the Fed’s public policy responsibilities: monetary policy. The president of each Reserve Bank participates in the Federal Open Market Committee (FOMC) meetings. Economists play a key role in briefing and generally supporting their president’s involvement in those meetings. I’m sure that I won’t be telling the people in this room anything new when I say that many of these economists are skilled at macroeconomic modeling. Indeed, there are many kinds of macroeconomic models, grounded in a wide range of underlying perspectives. To be most effective, an FOMC participant’s support team has to engage fully with this plethora of approaches.

I suspect, too, that many in this room will not be surprised to hear that to be effective, presidents of Reserve Banks need support from economists with expertise in financial economics. After all, the Fed implements its monetary policy actions through financial market transactions. Monetary policy advice needs to be grounded in a keen understanding of financial markets, and the linkages between those markets and the broader macroeconomy. As well, financial markets are important to policymakers as a source of information about the public’s expectations for the future. At the Minneapolis Fed, we continue to work on how best to use information in asset prices—as encoded in so-called risk-neutral probabilities—to inform monetary policy choices.³ This is a joint effort that involves several parts of the Bank, and we have benefited from interactions with other economists around the System and in academe. We see it as a critical area for future research.

What is perhaps less understood is that people who are not specialists in macroeconomics or finance also play a key role in monetary policy support. For example, the Fed is charged with making monetary policy so as to promote maximum employment. The challenge is that the level of employment that is indeed maximal is largely outside the control of monetary policy and, moreover, varies over time. Hence, the Fed engages in continual efforts to obtain measures of the maximum level of employment. These efforts are fundamentally grounded in the work of many labor economists around the System, but I’ll cite an important recent example done in Minneapolis. My research director, Sam Schulhofer-Wohl, and his co-author and former Minneapolis Fed economist Greg Kaplan closely studied the recent decline in internal migration in the United States.⁴ Some policymakers had expressed concern that this decline indicated that the Great Recession had caused a sudden increase in structural unemployment. But Sam and Greg’s research provided compelling evidence that this view was mistaken—rather, the decline in internal migration was better understood as being part of a very long-run trend.

Let me transit to another Fed responsibility: supervision of financial institutions. The financial crisis made clear the fundamental linkage between the condition of large financial institutions and the macroeconomy. That lesson has translated into a more complete integration of economists—with expertise in banking, finance and macroeconomics—and the supervision of financial institutions. Monetary policymakers continually assess systemic financial risks, and this assessment is informed in part by supervisory information. Conversely, economists contribute to the supervision process by helping to build a better understanding of risks that face the financial sector.

I could illustrate this Systemwide effort to build more connections between economics and supervision in many ways. I’ll just mention two of the several lines of attack undertaken in Minneapolis. Minneapolis Fed economist Motohiro Yogo and his co-author Ralph Koijen are studying the incentive effects of regulatory policies on insurers’ risk-taking. Their work has shed important new light on “shadow insurance” risks from off-balance-sheet liabilities of life insurance companies.⁵ As well, my head of supervision, Ron Feldman, and his team are using option price data—again, as encoded in risk-neutral probabilities—as a source of information about tail risks for large financial institutions.⁶

I’ve talked a lot about monetary policy and the supervision of financial institutions. But these are only two of the many public policy roles of Reserve Banks. Let me briefly mention a couple more: the payments system and community development. Reserve Banks have recently formulated an ambitious strategic plan regarding their responsibilities in the payments system—the variety of mechanisms by which people and businesses transfer funds to one another. This strategic plan was informed in part by contributions from a large number of economists around the System who specialize in payments systems. In terms of community development, Reserve Banks engage in a number of activities to encourage private-sector investment in low- and moderate-income communities. Microeconomic analysis underpins these activities in important ways. For example, in Minneapolis, over the past dozen years, our Community Development function has worked closely with tribal representatives on initiatives to help Native American tribes select and build a sound legal infrastructure that can support private business development in Indian Country. We are engaged in efforts to buttress this work by using microeconometric techniques to measure the impact of these legal infrastructure improvements on economic outcomes.

I have argued that Reserve Banks need a wide range of skills and perspectives to fulfill their public policy missions. These considerations have helped inform the evolution of our Research department in Minneapolis in the past four plus years since I became president. In that time, we’ve greatly expanded the group, by hiring folks from top universities like Stanford, Penn and Princeton, as well as from elsewhere in the Federal Reserve System. These new economists have skills in financial economics, labor economics, international economics, econometric forecasting and monetary economics. The department’s expansion has helped make the Minneapolis Fed even more agile and effective with respect to its public policy contributions, while maintaining its historical excellence with respect to independent research.

But the skill diversity that I’ve been emphasizing is valued throughout the Federal Reserve System, not just in Minneapolis. To see this, one need not look any further than the key Research leadership positions around the Federal Reserve System. The Research director in Philadelphia is an economist with expertise in banking. The Research director in Chicago is an economist with expertise in labor economics and industrial organization. The Research director in New York is an economist with expertise in payments systems.

I’ve described a Federal Reserve System in which each Reserve Bank has a broad-based group of economists. Some listeners might ask: Why not put all the economists in Washington? Or why not have each bank specialize in a different subfield of economics? I have a couple of answers to these questions. The first is grounded in the nature of monetary policymaking at the Federal Reserve. The essence of the Federal Reserve System is that each of the 12 Reserve Bank presidents brings a distinct perspective to monetary policy deliberations. But these perspectives need to be appropriately informed by economic analysis—and, as I’ve argued, that kind of support requires a broad range of skills to be effective.

Second, I view geographic diversity as a necessary ingredient to generating valuable intellectual diversity across the System. Back in the 1970s, the Minneapolis Fed Research department played a key role in fostering the “rational expectations revolution” that has helped transform the making of monetary policy around the world. Would these economists have played this same role had they been working in Washington—or anywhere else in the System, for that matter? I believe that the answer to this question is no. The ideas in the Research department were generated by synergistic interactions between Minneapolis Fed economists and University of Minnesota economists—synergies that owed a lot to the geographical proximity between the two institutions. I see those same intellectual synergies as critical to the Minneapolis Fed’s, and the System’s, thinking as we move forward.

Let me sum up.

Most of you know that many economists work in Reserve Banks. What I wanted to communicate to you today is that these economists have many different fields of specialization. This diversity is essential—Reserve Banks need that large variety of skills to fulfill our public policy missions. As a result, many kinds of economists can enjoy successful careers within the Federal Reserve. What it takes to be successful in our organization as an economist is extraordinary dedication to, and belief in, our public policy mission.

Endnotes

1 I thank Dave Fettig and Sam Schulhofer-Wohl for their helpful comments.

2 See Harold L. Cole and Lee E. Ohanian, “The Great Depression in the United States from a Neoclassical Perspective,” Federal Reserve Bank of Minneapolis Quarterly Review 23(1), 2–24, Winter 1999; Harold L. Cole and Lee E. Ohanian, “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy 112(4), 779–816, August 2004.

3 See Narayana Kocherlakota, “Optimal Outlooks,” presentation at Conference on Extracting and Understanding the Risk Neutral Probability Density from Options Prices, New York University Stern School of Business, New York, N.Y., Sept. 20, 2013.

4 See Greg Kaplan and Sam Schulhofer-Wohl, “Interstate Migration Has Fallen Less Than You Think: Consequences of Hot Deck Imputation in the Current Population Survey,” Demography 49(3), 1061–74, August 2012; Greg Kaplan and Sam Schulhofer-Wohl, “Understanding the Long-Run Decline in Interstate Migration,” Federal Reserve Bank of Minneapolis Working Paper 697, revised December 2013.

5 See Ralph S. J. Koijen and Motohiro Yogo, “The Cost of Financial Frictions for Life Insurers,” April 2013; Ralph S. J. Koijen and Motohiro Yogo, “Shadow Insurance,” November 2013

6 See Estimates of the Future Behavior of Asset Prices.

'The Crisis as a Classic Financial Panic'

Ben Bernanke on how the bank panic of 2007 is similar to the panic of 1907:

The Crisis as a Classic Financial Panic, by Chairman Ben S. Bernanke: I am very pleased to participate in this event in honor of Stanley Fischer. Stan was my teacher in graduate school, and he has been both a role model and a frequent adviser ever since. An expert on financial crises, Stan has written prolifically on the subject and has also served on the front lines, so to speak--notably, in his role as the first deputy managing director of the International Monetary Fund during the emerging market crises of the 1990s. Stan also helped to fight hyperinflation in Israel in the 1980s and, as the governor of that nation's central bank, deftly managed monetary policy to mitigate the effects of the recent crisis on the Israeli economy. Subsequently, as Israeli housing prices ran upward, Stan became an advocate and early adopter of macroprudential policies to preserve financial stability.

Stan frequently counseled his students to take a historical perspective, which is good advice in general, but particularly helpful for understanding financial crises, which have been around a very long time. Indeed, as I have noted elsewhere, I think the recent global crisis is best understood as a classic financial panic transposed into the novel institutional context of the 21st century financial system.¹ An appreciation of the parallels between recent and historical events greatly influenced how I and many of my colleagues around the world responded to the crisis.

Besides being the fifth anniversary of the most intense phase of the recent crisis, this year also marks the centennial of the founding of the Federal Reserve.² It's particularly appropriate to recall, therefore, that the Federal Reserve was itself created in response to a severe financial panic, the Panic of 1907. This panic led to the creation of the National Monetary Commission, whose 1911 report was a major impetus to the Federal Reserve Act, signed into law by President Woodrow Wilson on December 23, 1913. Because the Panic of 1907 fit the archetype of a classic financial panic in many ways, it's worth discussing its similarities and differences with the recent crisis.³ 

Like many other financial panics, including the most recent one, the Panic of 1907 took place while the economy was weakening; according to the National Bureau of Economic Research, a recession had begun in May 1907.⁴ Also, as was characteristic of pre-Federal Reserve panics, money markets were tight when the panic struck in October, reflecting the strong seasonal demand for credit associated with the harvesting and shipment of crops. The immediate trigger of the panic was a failed effort by a group of speculators to corner the stock of the United Copper Company. The main perpetrators of the failed scheme, F. Augustus Heinze and C.F. Morse, had extensive connections with a number of leading financial institutions in New York City. When the news of the failed speculation broke, depositor fears about the health of those institutions led to a series of runs on banks, including a bank at which Heinze served as president. To try to restore confidence, the New York Clearinghouse, a private consortium of banks, reviewed the books of the banks under pressure, declared them solvent, and offered conditional support--one of the conditions being that Heinze and his board step down. These steps were largely successful in stopping runs on the New York banks.

But even as the banks stabilized, concerns intensified about the financial health of a number of so-called trust companies--financial institutions that were less heavily regulated than national or state banks and which were not members of the Clearinghouse. As the runs on the trust companies worsened, the companies needed cash to meet the demand for withdrawals. In the absence of a central bank, New York's leading financiers, led by J.P. Morgan, considered providing liquidity. However, Morgan and his colleagues decided that they did not have sufficient information to judge the solvency of the affected institutions, so they declined to lend. Overwhelmed by a run, the Knickerbocker Trust Company failed on October 22, undermining public confidence in the remaining trust companies.

To satisfy their depositors' demands for cash, the trust companies began to sell or liquidate assets, including loans made to finance stock purchases. The selloff of shares and other assets, in what today we would call a fire sale, precipitated a sharp decline in the stock market and widespread disruptions in other financial markets. Increasingly concerned, Morgan and other financiers (including the future governor of the Federal Reserve Bank of New York, Benjamin Strong) led a coordinated response that included the provision of liquidity through the Clearinghouse and the imposition of temporary limits on depositor withdrawals, including withdrawals by correspondent banks in the interior of the country. These efforts eventually calmed the panic. By then, however, the U.S. financial system had been severely disrupted, and the economy contracted through the middle of 1908.

The recent crisis echoed many aspects of the 1907 panic. Like most crises, the recent episode had an identifiable trigger--in this case, the growing realization by market participants that subprime mortgages and certain other credits were seriously deficient in their underwriting and disclosures. As the economy slowed and housing prices declined, diverse financial institutions, including many of the largest and most internationally active firms, suffered credit losses that were clearly large but also hard for outsiders to assess. Pervasive uncertainty about the size and incidence of losses in turn led to sharp withdrawals of short-term funding from a wide range of institutions; these funding pressures precipitated fire sales, which contributed to sharp declines in asset prices and further losses. Institutional changes over the past century were reflected in differences in the types of funding that ran: In 1907, in the absence of deposit insurance, retail deposits were much more prone to run, whereas in 2008, most withdrawals were of uninsured wholesale funding, in the form of commercial paper, repurchase agreements, and securities lending. Interestingly, a steep decline in interbank lending, a form of wholesale funding, was important in both episodes. Also interesting is that the 1907 panic involved institutions--the trust companies--that faced relatively less regulation, which probably contributed to their rapid growth in the years leading up to the panic. In analogous fashion, in the recent crisis, much of the panic occurred outside the perimeter of traditional bank regulation, in the so-called shadow banking sector.⁵ 

The responses to the panics of 1907 and 2008 also provide instructive comparisons. In both cases, the provision of liquidity in the early stages was crucial. In 1907 the United States had no central bank, so the availability of liquidity depended on the discretion of firms and private individuals, like Morgan. In the more recent crisis, the Federal Reserve fulfilled the role of liquidity provider, consistent with the classic prescriptions of Walter Bagehot.⁶ The Fed lent not only to banks, but, seeking to stem the panic in wholesale funding markets, it also extended its lender-of-last-resort facilities to support nonbank institutions, such as investment banks and money market funds, and key financial markets, such as those for commercial paper and asset-backed securities.

In both episodes, though, liquidity provision was only the first step. Full stabilization requires the restoration of public confidence. Three basic tools for restoring confidence are temporary public or private guarantees, measures to strengthen financial institutions' balance sheets, and public disclosure of the conditions of financial firms. At least to some extent, Morgan and the New York Clearinghouse used these tools in 1907, giving assistance to troubled firms and providing assurances to the public about the conditions of individual banks. All three tools were used extensively in the recent crisis: In the United States, guarantees included the Federal Deposit Insurance Corporation's (FDIC) guarantees of bank debt, the Treasury Department's guarantee of money market funds, and the private guarantees offered by stronger firms that acquired weaker ones. Public and private capital injections strengthened bank balance sheets. Finally, the bank stress tests that the Federal Reserve led in the spring of 2009 and the publication of the stress-test findings helped restore confidence in the U.S. banking system. Collectively, these measures helped end the acute phase of the financial crisis, although, five years later, the economic consequences are still with us.

Once the fire is out, public attention turns to the question of how to better fireproof the system. Here, the context and the responses differed between 1907 and the recent crisis. As I mentioned, following the 1907 crisis, reform efforts led to the founding of the Federal Reserve, which was charged both with helping to prevent panics and, by providing an "elastic currency," with smoothing seasonal interest rate fluctuations. In contrast, reforms since 2008 have focused on critical regulatory gaps revealed by the crisis. Notably, oversight of the shadow banking system is being strengthened through the designation, by the new Financial Stability Oversight Council, of nonbank systemically important financial institutions (SIFIs) for consolidated supervision by the Federal Reserve, and measures are being undertaken to address the potential instability of wholesale funding, including reforms to money market funds and the triparty repo market.⁷ 

As we try to make the financial system safer, we must inevitably confront the problem of moral hazard. The actions taken by central banks and other authorities to stabilize a panic in the short run can work against stability in the long run, if investors and firms infer from those actions that they will never bear the full consequences of excessive risk-taking. As Stan Fischer reminded us following the international crises of the late 1990s, the problem of moral hazard has no perfect solution, but steps can be taken to limit it.⁸ First, regulatory and supervisory reforms, such as higher capital and liquidity standards or restriction on certain activities, can directly limit risk-taking. Second, through the use of appropriate carrots and sticks, regulators can enlist the private sector in monitoring risk-taking. For example, the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) process, the descendant of the bank stress tests of 2009, requires not only that large financial institutions have sufficient capital to weather extreme shocks, but also that they demonstrate that their internal risk-management systems are effective.⁹ In addition, the results of the stress-test portion of CCAR are publicly disclosed, providing investors and analysts information they need to assess banks' financial strength.

Of course, market discipline can only limit moral hazard to the extent that debt and equity holders believe that, in the event of distress, they will bear costs. In the crisis, the absence of an adequate resolution process for dealing with a failing SIFI left policymakers with only the terrible choices of a bailout or allowing a potentially destabilizing collapse. The Dodd-Frank Act, under the orderly liquidation authority in Title II, created an alternative resolution mechanism for SIFIs that takes into account both the need, for moral hazard reasons, to impose costs on the creditors of failing firms and the need to protect financial stability; the FDIC, with the cooperation of the Federal Reserve, has been hard at work fleshing out this authority.¹⁰ A credible resolution mechanism for systemically important firms will be important for reducing uncertainty, enhancing market discipline, and reducing moral hazard.

Our continuing challenge is to make financial crises far less likely and, if they happen, far less costly. The task is complicated by the reality that every financial panic has its own unique features that depend on a particular historical context and the details of the institutional setting. But, as Stan Fischer has done with unusual skill throughout his career, one can, by stripping away the idiosyncratic aspects of individual crises, hope to reveal the common elements. In 1907, no one had ever heard of an asset-backed security, and a single private individual could command the resources needed to bail out the banking system; and yet, fundamentally, the Panic of 1907 and the Panic of 2008 were instances of the same phenomenon, as I have discussed today. The challenge for policymakers is to identify and isolate the common factors of crises, thereby allowing us to prevent crises when possible and to respond effectively when not.

---

1. See Ben S. Bernanke (2012), "Some Reflections on the Crisis and the Policy Response," speech delivered at "Rethinking Finance," a conference sponsored by the Russell Sage Foundation and Century Foundation, New York, April 13. For the classic discussion of financial panics and the appropriate central bank response, see Walter Bagehot ([1873] 1897), Lombard Street: A Description of the Money Market (New York: Charles Scribner's Sons).

2. Information on the centennial of the Federal Reserve System is available at www.federalreserve.gov/aboutthefed/centennial/about.htm.

3. The Panic of 1907 is discussed in a number of sources, including O.M.W. Sprague (1910), A History of Crises under the National Banking System (PDF), National Monetary Commission (Washington: U.S. Government Printing Office), and, with a focus on its monetary consequences, Milton Friedman and Anna Jacobson Schwartz (1963), A Monetary History of the United States, 1867-1960 (Princeton, N.J.: Princeton University Press). An accessible discussion of the episode, from which this speech draws heavily, can be found in Jon R. Moen and Ellis W. Tallman (1990), "Lessons from the Panic of 1907 (PDF)," Federal Reserve Bank of Atlanta, Economic Review, May/June, pp. 2-13.

4. See Charles W. Calomiris and Gary Gorton (1991), "The Origins of Banking Panics: Models, Facts, and Bank Regulation," in R. Glenn Hubbard, ed., Financial Markets and Financial Crises (Chicago: University of Chicago Press), pp. 109-74.

5. As discussed in Bernanke, "Some Reflections on the Crisis" (see note 1), shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions--but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies.

6. See Bagehot, Lombard Street, in note 1.

7. For a more comprehensive discussion of recent changes in the regulatory framework, see Daniel K. Tarullo (2013), " Evaluating Progress in Regulatory Reforms to Promote Financial Stability," speech delivered at the Peterson Institute for International Economics, Washington, May 3.

8. See Stanley Fischer (1999), "On the Need for an International Lender of Last Resort," Journal of Economic Perspectives, vol. 13 (Fall), pp. 85-104.

9. For example, see Board of Governors of the Federal Reserve System (2013), Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice (PDF) (Washington: Board of Governors, August).

10. For a more detailed discussion, see Daniel K. Tarullo (2013), "Toward Building a More Effective Resolution Regime: Progress and Challenges," speech delivered at "Planning for the Orderly Resolution of a Global Systemically Important Bank," a conference sponsored by the Federal Reserve Board and the Federal Reserve Bank of Richmond, Washington, October 18.

'A Century of U.S. Central Banking: Goals, Frameworks, Accountability'

Ben Bernanke:

A Century of U.S. Central Banking: Goals, Frameworks, Accountability, by Ben Bernanke, Federal Reserve: I'd like to thank the National Bureau of Economic Research for organizing this conference in recognition of the Federal Reserve's centennial, and I'm glad to have the opportunity to participate. In keeping with the spirit of the conference, my remarks today will take a historical perspective. I will leave discussion of current policy to today's question-and-answer session and, of course, to my congressional testimony next week.

Today, I'll discuss the evolution over the past 100 years of three key aspects of Federal Reserve policymaking: the goals of policy, the policy framework, and accountability and communication. The changes over time in these three areas provide a useful perspective, I believe, on how the role and functioning of the Federal Reserve have changed since its founding in 1913, as well as some lessons for the present and for the future. I will pay particular attention to several key episodes of the Fed's history, all of which have been referred to in various contexts with the adjective "Great" attached to them: the Great Experiment of the Federal Reserve's founding, the Great Depression, the Great Inflation and subsequent disinflation, the Great Moderation, and the recent Great Recession.

The Great Experiment In the words of one of the authors of the Federal Reserve Act, Robert Latham Owen, the Federal Reserve was established to "provide a means by which periodic panics which shake the American Republic and do it enormous injury shall be stopped."¹ In short, the original goal of the Great Experiment that was the founding of the Fed was the preservation of financial stability.² At the time, the standard view of panics was that they were triggered when the needs of business and agriculture for liquid funds outstripped the available supply--as when seasonal plantings or shipments of crops had to be financed, for example--and that panics were further exacerbated by the incentives of banks and private individuals to hoard liquidity during such times.³ The new institution was intended to relieve such strains by providing an "elastic" currency--that is, by providing liquidity as needed to individual member banks through the discount window; commercial banks, in turn, would then be able to accommodate their customers. Interestingly, although congressional advocates hoped the creation of the Fed would help prevent future panics, they did not fully embrace the idea that the Fed should help end ongoing panics by serving as lender of last resort, as had been recommended by the British economist and writer Walter Bagehot.⁴ Legislators imposed limits on the Federal Reserve's ability to lend in response to panics, for example, by denying nonmember banks access to the discount window and by restricting the types of collateral that the Fed could accept.⁵ 

The framework that the Federal Reserve employed in its early years to promote financial stability reflected in large measure the influence of the so-called real bills doctrine, as well as the fact that the United States was on the gold standard.⁶ In the framework of the real bills doctrine, the Federal Reserve saw its function as meeting the needs of business for liquidity--consistent with the idea of providing an elastic currency--with the ultimate goal of supporting financial and economic stability.⁷ When business activity was increasing, the Federal Reserve helped accommodate the need for credit by supplying liquidity to banks; when business was contracting and less credit was needed, the Fed reduced the liquidity in the system.

As I mentioned, the Federal Reserve pursued this approach to policy in the context of the gold standard. Federal Reserve notes were redeemable in gold on demand, and the Fed was required to maintain a gold reserve equal to 40 percent of outstanding notes. However, contrary to the principles of an idealized gold standard, the Federal Reserve often took actions to prevent inflows and outflows of gold from being fully translated into changes in the domestic money supply.⁸ This practice, together with the size of the U.S. economy, gave the Federal Reserve considerable autonomy in monetary policy and, in particular, allowed the Fed to conduct policy according to the real bills doctrine without much hindrance.

The policy framework of the Fed's early years has been much criticized in retrospect. Although the gold standard did not appear to have greatly constrained U.S. monetary policy in the years after the Fed's founding, subsequent research has highlighted the extent to which the international gold standard served to destabilize the global economy in the late 1920s and early 1930s.⁹ Likewise, economic historians have pointed out that, under the real bills doctrine, the Fed increased the money supply precisely at those times at which business activity and upward pressures on prices were strongest; that is, monetary policy was procyclical. Thus, the Fed's actions tended to increase rather than decrease the volatility in economic activity and prices.¹⁰ 

During this early period, the new central bank did make an important addition to its menu of policy tools. Initially, the Fed's main tools were the quantity of its lending through the discount window and the interest rate at which it lent, the discount rate. Early on, however, to generate earnings to finance its operations, the Federal Reserve began purchasing government securities in the open market--what came to be known as open market operations. In the early 1920s, Fed officials discovered that these operations affected the supply and cost of bank reserves and, consequently, the terms on which banks extended credit to their customers. Subsequently, of course, open market operations became a principal monetary policy tool, one that allowed the Fed to interact with the broader financial markets, not only with banks.¹¹ 

I've discussed the original mandate and early policy framework of the Fed. What about its accountability to the public? As this audience knows, when the Federal Reserve was established, the question of whether it should be a private or a public institution was highly contentious. The compromise solution created a hybrid Federal Reserve System. The System was headed by a governmentally appointed Board, which initially included the Secretary of the Treasury and the Comptroller of the Currency. But the 12 regional Reserve Banks were placed under a mixture of public and private oversight, including board members drawn from the private sector, and they were given considerable scope to make policy decisions that applied to their own Districts. For example, Reserve Banks were permitted to set their own discount rates, subject to a minimum set by the Board.

While the founders of the Federal Reserve hoped that this new institution would provide financial and hence economic stability, the policy framework and the institutional structure would prove inadequate to the challenges the Fed would soon face.

The Great Depression The Great Depression was the Federal Reserve's most difficult test. Tragically, the Fed failed to meet its mandate to maintain financial stability. In particular, although the Fed provided substantial liquidity to the financial system following the 1929 stock market crash, its response to the subsequent banking panics was limited at best; the widespread bank failures and the collapse in money and credit that ensued were major sources of the economic downturn.¹² Bagehot's dictum to lend freely at a penalty rate in the face of panic appeared to have few adherents at the Federal Reserve of that era.¹³ 

Economists have also identified a number of instances from the late 1920s to the early 1930s when Federal Reserve officials, in the face of the sharp economic contraction and financial upheaval, either tightened monetary policy or chose inaction. Some historians trace these policy mistakes to the early death of Benjamin Strong, governor of the Federal Reserve Bank of New York, in 1928, which left the decentralized system without an effective leader.¹⁴ Whether valid or not, this hypothesis raises the interesting question of what intellectual framework an effective leader would have drawn on at the time to develop and justify a more activist monetary policy. The degree to which the gold standard actually constrained U.S. monetary policy during the early 1930s is debated; but the gold standard philosophy clearly did not encourage the sort of highly expansionary policies that were needed.¹⁵ The same can be said for the real bills doctrine, which apparently led policymakers to conclude, on the basis of low nominal interest rates and low borrowings from the Fed, that monetary policy was appropriately supportive and that further actions would be fruitless.¹⁶ Historians have also noted the prevalence at the time of yet another counterproductive doctrine: the so-called liquidationist view, that depressions perform a necessary cleansing function.¹⁷ It may be that the Federal Reserve suffered less from lack of leadership in the 1930s than from the lack of an intellectual framework for understanding what was happening and what needed to be done.

The Fed's inadequate policy frameworks ultimately collapsed under the weight of economic failures, new ideas, and political developments. The international gold standard was abandoned during the 1930s. The real bills doctrine likewise lost prestige after the disaster of the 1930s; for example, the Banking Act of 1935 instructed the Federal Reserve to use open market operations with consideration of "the general credit situation of the country," not just to focus narrowly on short-term liquidity needs.¹⁸ The Congress also expanded the Fed's ability to provide credit through the discount window, allowing loans to a broader array of counterparties, secured by a broader variety of collateral.¹⁹ 

The experience of the Great Depression had major ramifications for all three aspects of the Federal Reserve I am discussing here: its goals, its policy framework, and its accountability to the public. With respect to goals, the high unemployment of the Depression--and the fear that high unemployment would return after World War II--elevated the maintenance of full employment as a goal of macroeconomic policy. The Employment Act of 1946 made the promotion of employment a general objective for the federal government. Although the Fed did not have a formal employment goal until the Federal Reserve Reform Act of 1977 codified "maximum employment," along with "stable prices," as part of the Fed's so-called dual mandate, earlier legislation nudged the central bank in that direction.²⁰ For example, legislators described the intent of the Banking Act of 1935 as follows: "To increase the ability of the banking system to promote stability of employment and business, insofar as this is possible within the scope of monetary action and credit administration."²¹ 

The policy framework to support this new approach reflected the development of macroeconomic theories--including the work of Knut Wicksell, Irving Fisher, Ralph Hawtrey, Dennis Robertson, and John Maynard Keynes--that laid the foundations for understanding how monetary policy could affect real activity and employment and help reduce cyclical fluctuations. At the same time, the Federal Reserve became less focused on its original mandate of preserving financial stability, perhaps in part because it felt superseded by the creation during the 1930s of the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, along with other reforms intended to make the financial system more stable.

In the area of governance and accountability to the public, policymakers also recognized the need for reforms to improve the Federal Reserve's structure and decisionmaking. The Banking Act of 1935 simultaneously bolstered the legal independence of the Federal Reserve and provided for stronger central control by the Federal Reserve Board. In particular, the act created the modern configuration of the Federal Open Market Committee (FOMC), giving the Board the majority of votes on the Committee, while removing the Secretary of the Treasury and the Comptroller of the Currency from the Board. In practice, however, the Treasury continued to have considerable sway over monetary policy after 1933, with one economic historian describing the Fed as "in the back seat."²² During World War II, the Federal Reserve used its tools to support the war financing efforts. However, even after the war, Federal Reserve policy remained subject to considerable Treasury influence. It was not until the 1951 Accord with the Treasury that the Federal Reserve began to recover genuine independence in setting monetary policy.

The Great Inflation and Disinflation Once the Federal Reserve regained its policy independence, its goals centered on the price stability and employment objectives laid out in the Employment Act of 1946. In the early postwar decades, the Fed used open market operations and the discount rate to influence short-term market interest rates, and the federal funds rate gradually emerged as the preferred operating target. Low and stable inflation was achieved for most of the 1950s and the early 1960s. However, beginning in the mid-1960s, inflation began a long climb upward, partly because policymakers proved to be too optimistic about the economy's ability to sustain rapid growth without inflation.²³ 

Two mechanisms might have mitigated the damage from that mistaken optimism. First, a stronger policy response to inflation--more like that observed in the 1950s--certainly would have helped.²⁴ Second, Fed policymakers could have reacted to continued high readings on inflation by adopting a more realistic assessment of the economy's productive potential.²⁵ Instead, policymakers chose to emphasize so-called cost-push and structural factors as sources of inflation and saw wage- and price-setting as having become insensitive to economic slack.₂₆ This perspective, which contrasted sharply with Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon," led to Fed support for measures such as wage and price controls rather than monetary solutions to address inflation.²⁷ A further obstacle was the view among many economists that the gains from low inflation did not justify the costs of achieving it.²⁸ 

The consequence of the monetary framework of the 1970s was two bouts of double-digit inflation. Moreover, by the end of the decade, lack of commitment to controlling inflation had clearly resulted in inflation expectations becoming "unanchored," with high estimates of trend inflation embedded in longer-term interest rates.

As you know, under the leadership of Chairman Paul Volcker, the Federal Reserve in 1979 fundamentally changed its approach to the issue of ensuring price stability. This change involved an important rethinking on the part of policymakers. By the end of the 1970s, Federal Reserve officials increasingly accepted the view that inflation is a monetary phenomenon, at least in the medium and longer term; they became more alert to the risks of excessive optimism about the economy's potential output; and they placed renewed emphasis on the distinction between real--that is, inflation-adjusted--and nominal interest rates.²⁹ The change in policy framework was initially tied to a change in operating procedures that put greater focus on growth in bank reserves, but the critical change--the willingness to respond more vigorously to inflation--endured even after the Federal Reserve resumed its traditional use of the federal funds rate as the policy instrument.³⁰ The new regime also reflected an improved understanding of the importance of providing a firm anchor, secured by the credibility of the central bank, for the private sector's inflation expectations.³¹ Finally, it entailed a changed view about the dual mandate, in which policymakers regarded achievement of price stability as helping to provide the conditions necessary for sustained maximum employment.³² 

The Great Moderation Volcker's successful battle against inflation set the stage for the so-called Great Moderation of 1984 to 2007, during which the Fed enjoyed considerable success in achieving both objectives of its dual mandate. Financial stability remained a goal, of course. The Federal Reserve monitored threats to financial stability and responded when the financial system was upset by events such as the 1987 stock market crash and the terrorist attacks of 2001. More routinely, it shared supervisory duties with other banking agencies. Nevertheless, for the most part, financial stability did not figure prominently in monetary policy discussions during these years. In retrospect, it is clear that macroeconomists--both inside and outside central banks--relied too heavily during that period on variants of the so-called Modigliani-Miller theorem, an implication of which is that the details of the structure of the financial system can be ignored when analyzing the behavior of the broader economy.

An important development of the Great Moderation was the increasing emphasis that central banks around the world put on communication and transparency, as economists and policymakers reached consensus on the value of communication in attaining monetary policy objectives.³³ Federal Reserve officials, like those at other central banks, had traditionally been highly guarded in their public pronouncements. They believed, for example, that the ability to take markets by surprise was important for influencing financial conditions.³⁴ Thus, although Fed policymakers of the 1980s and early 1990s had become somewhat more explicit about policy objectives and strategy, the same degree of transparency was not forthcoming on monetary policy decisions and operations.³⁵ The release of a postmeeting statement by the FOMC, a practice that began in 1994, was, therefore, an important watershed. Over time, the statement was expanded to include more detailed information about the reason for the policy decision and an indication of the balance of risks.³⁶ 

In addition to improving the effectiveness of monetary policy, these developments in communications also enhanced the public accountability of the Federal Reserve. Accountability is, of course, essential for policy independence in a democracy. During this period, economists found considerable evidence that central banks that are afforded policy independence in the pursuit of their mandated objectives deliver better economic outcomes.³⁷ 

One cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms, and financial regulators into paying insufficient attention to building risks must have some truth in it. I don't think we should conclude, though, that we therefore should not strive to achieve economic stability. Rather, the right conclusion is that, even in (or perhaps, especially in) stable and prosperous times, monetary policymakers and financial regulators should regard safeguarding financial stability to be of equal importance as--indeed, a necessary prerequisite for--maintaining macroeconomic stability.

Macroeconomists and historians will continue to debate the sources of the remarkable economic performance during the Great Moderation.³⁸ My own view is that the improvements in the monetary policy framework and in monetary policy communication, including, of course, the better management of inflation and the anchoring of inflation expectations, were important reasons for that strong performance. However, we have learned in recent years that while well-managed monetary policy may be necessary for economic stability, it is not sufficient.

The Financial Crisis, the Great Recession, and Today It has been about six years since the first signs of the financial crisis appeared in the United States, and we are still working to achieve a full recovery from its effects. What lessons should we take for the future from this experience, particularly in the context of a century of Federal Reserve history?

The financial crisis and the ensuing Great Recession reminded us of a lesson that we learned both in the 19th century and during the Depression but had forgotten to some extent, which is that severe financial instability can do grave damage to the broader economy. The implication is that a central bank must take into account risks to financial stability if it is to help achieve good macroeconomic performance. Today, the Federal Reserve sees its responsibilities for the maintenance of financial stability as coequal with its responsibilities for the management of monetary policy, and we have made substantial institutional changes in recognition of this change in goals. In a sense, we have come full circle, back to the original goal of the Federal Reserve of preventing financial panics.³⁹ 

How should a central bank enhance financial stability? One means is by assuming the lender-of-last-resort function that Bagehot understood and described 140 years ago, under which the central bank uses its power to provide liquidity to ease market conditions during periods of panic or incipient panic. The Fed's many liquidity programs played a central role in containing the crisis of 2008 to 2009. However, putting out the fire is not enough; it is also important to foster a financial system that is sufficiently resilient to withstand large financial shocks. Toward that end, the Federal Reserve, together with other regulatory agencies and the Financial Stability Oversight Council, is actively engaged in monitoring financial developments and working to strengthen financial institutions and markets. The reliance on stronger regulation is informed by the success of New Deal regulatory reforms, but current reform efforts go even further by working to identify and defuse risks not only to individual firms but to the financial system as a whole, an approach known as macroprudential regulation.

Financial stability is also linked to monetary policy, though these links are not yet fully understood. Here the Fed's evolving strategy is to make monitoring, supervision, and regulation the first line of defense against systemic risks; to the extent that risks remain, however, the FOMC strives to incorporate these risks in the cost-benefit analysis applied to all monetary policy actions.⁴⁰ 

What about the monetary policy framework? In general, the Federal Reserve's policy framework inherits many of the elements put in place during the Great Moderation. These features include the emphasis on preserving the Fed's inflation credibility, which is critical for anchoring inflation expectations, and a balanced approach in pursuing both parts of the Fed's dual mandate in the medium term. We have also continued to increase the transparency of monetary policy. For example, the Committee's communications framework now includes a statement of its longer-run goals and monetary policy strategy.⁴¹ In that statement, the Committee indicated that it judged that inflation at a rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures) is most consistent over the longer run with the FOMC's dual mandate. FOMC participants also regularly provide estimates of the longer-run normal rate of unemployment; those estimates currently have a central tendency of 5.2 to 6.0 percent. By helping to anchor longer-term expectations, this transparency gives the Federal Reserve greater flexibility to respond to short-run developments. This framework, which combines short-run policy flexibility with the discipline provided by the announced targets, has been described as constrained discretion.⁴² Other communication innovations include early publication of the minutes of FOMC meetings and quarterly postmeeting press conferences by the Chairman.

The framework for implementing monetary policy has evolved further in recent years, reflecting both advances in economic thinking and a changing policy environment. Notably, following the ideas of Lars Svensson and others, the FOMC has moved toward a framework that ties policy settings more directly to the economic outlook, a so-called forecast-based approach.⁴³ In particular, the FOMC has released more detailed statements following its meetings that have related the outlook for policy to prospective economic developments and has introduced regular summaries of the individual economic projections of FOMC participants (including for the target federal funds rate). The provision of additional information about policy plans has helped Fed policymakers deal with the constraint posed by the effective lower bound on short-term interest rates; in particular, by offering guidance about how policy will respond to economic developments, the Committee has been able to increase policy accommodation, even when the short-term interest rate is near zero and cannot be meaningfully reduced further.⁴⁴ The Committee has also sought to influence interest rates further out on the yield curve, notably through its securities purchases. Other central banks in advanced economies, also confronted with the effective lower bound on short-term interest rates, have taken similar measures.

In short, the recent crisis has underscored the need both to strengthen our monetary policy and financial stability frameworks and to better integrate the two. We have made progress on both counts, but more needs to be done. In particular, the complementarities among regulatory and supervisory policies (including macroprudential policy), lender-of-last-resort policy, and standard monetary policy are increasingly evident. Both research and experience are needed to help the Fed and other central banks develop comprehensive frameworks that incorporate all of these elements. The broader conclusion is what might be described as the overriding lesson of the Federal Reserve's history: that central banking doctrine and practice are never static. We and other central banks around the world will have to continue to work hard to adapt to events, new ideas, and changes in the economic and financial environment.

References

'Focusing on Low- and Moderate-Income Working Americans'

It's nice to see the Fed thinking in these terms. This is from a speech by Federal Reserve Governor Sarah Bloom Raskin:

Focusing on Low- and Moderate-Income Working Americans: ... Challenges Posed by Labor Market Conditions
The Great Recession stands out for the magnitude of job losses we experienced throughout the downturn. These factors have hit low- and moderate-income Americans the hardest. The poverty rate has risen sharply since the onset of the recession, after a decade of relative stability, and it now stands at 15 percent--significantly higher than the average over the past three decades.¹ And those who are fortunate enough to have held onto their jobs have seen their hourly compensation barely keep pace with the cost of living over the past three years.² ...

About two-thirds of all job losses resulting from the recession were in moderate-wage occupations, such as manufacturing, skilled construction, and office administration jobs. However, these occupations have accounted for less than one-quarter of subsequent job gains. The declines in lower-wage occupations--such as retail sales and food service--accounted for about one-fifth of job loss, but a bit more than one-half of subsequent job gains. Indeed, recent job gains have been largely concentrated in lower-wage occupations such as retail sales, food preparation, manual labor, home health care, and customer service.³

Furthermore, wage growth has remained more muted than is typical during an economic recovery. To some extent, the rebound is being driven by the low-paying nature of the jobs that have been created. ... In fact, while average wages have continued to increase steadily for persons who have remained employed all along, the average wage for new hires have actually declined since 2010.⁴

The faces of low-wage Americans are diverse. They include people of varying employment status, race, gender, immigration status, and other characteristics. Many such Americans are attached to the workforce and are deeply committed to both personal success and to making a contribution to society. For purposes of reference, in 2011, low wage was defined as $23,005 per year or $11.06 per hour.⁵

Today, about one-quarter of all workers are considered "low wage." They are sanitation workers, office receptionists, and nursing assistants; they are single mothers of three who worry: How will I be able to send my children to college? What if my landlord raises the rent this year? Tens of millions of Americans are the people who ask themselves these questions every day.

This diverse group of workers faces numerous barriers when trying to access the labor market or advance in their current positions. ...

We know, for example, that location presents thorny challenges for many low-wage workers. Within metropolitan areas, jobs are not spread out evenly and job creation tends to be depressed in low-income communities. As a result, many low-wage workers face long commutes and serious commuting difficulties due to less reliable transportation and an inadequate transportation infrastructure. Moreover, a number of low-wage employees work non-standard hours, exacerbating both transportation and childcare issues, as well as personal health problems.⁷

Traditionally, many workers find jobs through social networks and through personal connections that they have to the labor market. But, because low-income individuals are typically less mobile, more isolated, and less socially connected than other people, they are often left out of the social networks that, in practice, lead to jobs for most Americans. ...

[T]he 21^st century labor market is increasingly complex; it continues to generate new challenges. For example, growth in sectors such as green industries and advanced manufacturing is creating jobs, but these jobs may demand different skills. Access to reliable information becomes critical for workers who are considering a new job, and must carefully weigh the skills and credentials required by potential employers with the cost of training and the likelihood of gaining employment.

And, more and more, employers are requiring post-secondary credentials. Today, a high school diploma alone is less likely to qualify an individual for a job with a path toward meaningful advancement. And, as demand for more credentials increases, workers who lack those credentials will find it increasingly difficult to gain upward mobility in the job market.

Contingent Work
Many employers are looking to make the employment relationship more flexible, and so are increasingly relying on part-time work and a variety of arrangements popularly known as "contingent work." This trend toward a more flexible workforce will likely continue. For example, while temporary work accounted for 10 percent of job losses during the recession, these jobs have accounted for more than 25 percent of net employment gains since the reces­sion ended.¹⁰ In fact, temporary help is rapidly approaching a new record, and businesses' use of staffing services continues to increase.¹¹

Contingent employment is arguably a sensible response to today's competitive marketplace. Contingent arrangements allow firms to maximize workforce flexibility in the face of seasonal and cyclical forces. The flexibility may be beneficial for workers who want or need time to address their family needs. However, workers in these jobs often receive less pay and fewer benefits than traditional full-time or "permanent" workers, are much less likely to benefit from the protections of labor and employment laws, and often have no real pathway to upward mobility in the workplace.¹²

Many workers who hold contingent positions do so involuntarily. Department of Labor statistics tell us that 8 million Americans say they are working part-time jobs but would like full-time jobs.¹³ These are the people in our communities who are "part time by necessity." As businesses increase their reliance on independent contractors and part-time, temporary, and seasonal positions, workers today bear far more of the responsibility and risk for managing their careers and financial security. Indeed, the expansion of contingent work has contributed to the increasing gap between high- and low-wage workers and to the increasing sense of insecurity among workers.¹⁴

Flexible and part-time arrangements can present great opportunities to some workers, but the substantial increase in part-time workers does raise a number of concerns. Part-time workers are particularly vulnerable to personal shocks due to lower levels of compensation, the absence of meaningful benefits, and even a lack of paid sick or personal days. Not surprisingly, turnover is high in these part-time jobs.

Access to Credit
The economic marginalization that comes with the growth of part-time and low-paying jobs is exacerbated by inadequate access to credit for many working Americans. Ideally, people chronically short of cash would have access to safe and sound financial institutions that could provide reliable and affordable access to credit as well as good savings plans. Unfortunately, many working Americans have no practical access to reasonably priced financial products with safe features, much less the kind of safe and fair credit that is available to wealthier consumers.

Working Americans have several core financial needs. They need a safe, accessible, and affordable method to deposit or cash checks, receive deposits, pay bills, and accrue savings. They may also need access to credit to tide them over until their next cash infusion arrives. They may be coming up short on paying their rent, their mortgage, an emergency medical expense, or an unexpected car repair. They may want access to a savings vehicle that, down the road, will help them pay for these items and for education or further training, or start a business. And many want some form of non-cash payment method to conduct transactions that are difficult or impossible to conduct using cash.

Products and services that serve these core financial needs are not consistently available at competitive rates to working Americans. Those with low and moderate incomes may have insufficient income or assets to meet the relatively high requirements needed to establish a credit history. Others may have problems in their credit history that inhibit their ability to borrow on competitive terms.

Many workers simply may not have banks in their communities, or may not have access to banks that actually compete with each other in terms of pricing or customer service. There is a growing trend toward greater concentration of financial assets at fewer banks. In my mind, this raises doubts about whether banking services will continue to be provided at competitive rates to all income levels of customers wherever they may live. ... While branch-building has been on the rise, indications are that the increase in the number of bank offices has not occurred evenly across neighborhoods of varying income.¹⁵

In fact, a significant number of low- and moderate-income families have become--or are at risk of becoming--financially marginalized. The percentage of families earning $15,000 per year or less who reported that they have no bank account increased between 2007 and 2009 such that more than one in four families was unbanked. Families slightly further up the income distribution, earning between $25,000 and $30,000 per year, are also financially marginalized: 13 percent report being unbanked and almost 24 percent report being underbanked.¹⁶

This combination of economic insecurity and financial marginalization has incentivized more low- and moderate-income families to seek out alternative financial service providers to meet their financial needs. Some of the providers they find, such as check-cashers and outfits furnishing advance loans on paychecks, can lead unwary workers into very deep financial holes. ...

There is no simple cure to these conditions, but government policymakers need to focus seriously on the problems, not simply because of notions of fairness and justice, but because the economy's ability to produce a stable quality of living for millions of people is at stake. Our country cannot achieve prosperity without addressing the powerful undertow created by flat wages and tenuous financial security for so many millions of Americans.

The Role of Monetary Policy
So how can the Federal Reserve address these challenges? Let me start with monetary policy. Congress has directed the Federal Reserve to use monetary policy to promote maximum employment and price stability. The Federal Reserve's primary monetary policy tool is its ability to influence the level of interest rates. Federal Reserve policymakers pushed short-term interest rates down nearly to zero as the financial crisis spread and the recession worsened in 2007 and 2008. By late 2008, it was clear that still more policy stimulus was necessary to turn the recession around. The Federal Reserve could not push short-term interest rates down further, but it could--and did--use the unconventional policy tools to bring longer-term interest rates such as mortgage rates down further.

Fed policymakers intend to keep interest rates low for a considerable time to promote a stronger economic recovery, a substantial improvement in labor market conditions, and greater progress toward maximum employment in a context of price stability. Both anecdotal evidence and a wide range of economic indicators show that these attempts are working to strengthen the recovery and that the labor market is improving.

Nonetheless, and again, the millions of people who would prefer to work full time can find only part-time work. While the Federal Reserve's monetary policy tools can be effective in promoting stronger economic recovery and job gains, they have little effect on the types of jobs that are created, particularly over the longer term. So, while monetary policy can help, it does not address all of the challenges that low- and moderate-income workers are confronting. That said, the existing mandate regarding maximum employment requires policymakers on the Federal Open Market Committee (FOMC) to understand labor market dynamics, which obviously must include an understanding of low- and moderate-income workers.

Regulatory and Supervisory Touchpoints
In addition to monetary policy, the Federal Reserve's regulatory and supervisory policies have the potential to address some of the challenges faced by low-income communities and consumers. ... If banking practices are undermining the ability of the economically marginalized to become financially included and to access the credit they need in an affordable way, regulators must move in quickly...

Swift and decisive corrective action is not always how federal bank regulators have responded ... in the past. In my view, for example, regulators' response to the rampant, long-running problems in loan-servicing practices at large financial institutions was not swift and was not decisive. ...

Fed Watch: Bullard and the "Fiscalization" of Monetary Policy

Tim Duy:

Bullard and the "Fiscalization" of Monetary Policy, by Tim Duy: I am struggling with the latest speech by St. Louis Federal Reserve President James Bullard. The speech is titled "The Global Battle Over Central Bank Independence," but in the process confuses fiscal policy stabilization as necessarily a threat to central bank independence, travels down a bizarre road that appears to be a misunderstanding of European monetary policy, and misses the obvious example of recent events in Japan.

Bullard begins with a description of the conventional wisdom of the relationship between fiscal and monetary policy. Basically, the former should focus on the medium- and long-run but is poorly suited for short-run stabilization. Such stabilization is the purview of monetary policy, or, more accurately, an independent monetary authority. Bullard quickly goes off the rails:

• The central banks in the G-7 encountered the zero lower bound on nominal interest rates.
• This led many to talk about the need for fiscal authorities to step up and conduct macroeconomic stabilization policy.
• However, the usual political hurdles asserted themselves and led to a hodgepodge of fiscal policy responses not particularly well-timed with macroeconomic events.

By itself, the zero bound did not give rise to increased interest in stabilization though fiscal policy. Instead, it was the inability of central banks to stabilize activity that raised the focus on fiscal policy. Consider the gap between private saving and investment:

Further, consider the gap across the era of the Great Moderation:

So, what's difference? The magnitude of the dislocation. While it is reasonable to believe that monetary policy is the preferable stabilization tool for relatively small perturbations in economic activity, it is not evident that the same is true for large perturbations, especially when the economy is at the zero bound. Indeed, it is the persistence of significant output gaps that triggered the interest in fiscal policy, not the zero bound itself. Does Bullard really believe that the US economy would be in better shape in the absence of a fiscal response?

It is also not clear what "political hurdles" Bullard is referring to, but I would say that the chief hurdle to effective fiscal policy is the rise of the austerians, those that believe that growth is achieved only by reducing deficits. One would think that by now the events in Europe had discredited this opinion as it is increasingly evident that fiscal multipiers are greater than anticipated, but Bullard is not about to be dissuaded.

Bullard cites evidence that monetary policy still provides effective stabilization policy:

• Inflation has generally stayed near target instead of falling dramatically.

Wow, really? He completely ignores evidence that inflation will not fall dramatically in the presence of downward nominal wage rigidities. Moreover, he completely ignores high unemployment or the persistent output gap. And even if you believe that monetary policy can effectively stabilize the economy, you probably are appalled that Bullard believes that the economy has been stabilized in spite of the inability of the Federal Reserve to stabilize the path of nominal GDP.

Bullard then takes a bizarre turn:

• Nevertheless, many see fiscal stabilization policy as desirable in the current context.
• One idea: Suggest that the central bank take actions that are cumbersome to accomplish through a democratically-elected body.

What are these actions? Bullard tries to further his case with recent European monetary policy:

• The European Central Bank recently announced an “outright monetary transactions” (OMT) program.
• This program has been widely interpreted as a promise to buy the sovereign debt of individual nations.
• A key element of the program is that purchases, should they occur, are conditional on the nation meeting certain fiscal targets.
• Purchases would be sterilized, so that the program is not the same as U.S.- and U.K.-style quantitative easing.
• The program has been regarded as “successful” so far.

Now Bullard seems to be saying is that when fiscal policymakers fail (as he assumes they will), then we will turn to monetary policymakers to enact fiscal policy. Now we have apples and oranges. I thought we were on the topic of whether or not fiscal policy can be used as a short-run stabilization tool. Only in an austerian fantasy-land is fiscal policy stabilizing the European economy. This isn't easy to sort out, but Bullard is saying that monetary policymakers in Europe are becoming fiscal policymakers. Bullard seems to be trying to make the argument that monetary policymakers are losing their independence in the process.

The problem is that if anything the opposite is true. It is the fiscal policymakers who are at the mercy of the European Central Bank. Bullard made a turn into the surreal world of European economic policy, where up is down. Bullard continues:

• This is “fiscalization” of monetary policy: Asking the central bank to take actions far outside the remit of monetary policy - The analog in the U.S. would be a promise to purchase, or even monetize, state debt in exchange for the state maintaining a fiscal program considered prudent by the central bank.
• Assistance like this from a central authority to a region is best brokered through the political process in democratically-elected bodies.
• In Europe, the ECB is in essence substituting for a weak pan-European central government.

Yes, the ECB is substituting for a fundamental structural problem in Europe, the lack of a fiscal authority (and doing it poorly, for that matter). This shouldn't happen in the US, where the Fed can pass the buck to Congress and the President. And I agree that monetary policymakers should resist crossing into fiscal policy. But Europe is a whole different world. The ECB acted kicking and screaming because if they didn't the whole European experiment would have collapsed at this point. The ECB was forced to actually do the job of a central bank by acting as lender of last resort of the fiscal authorities, and then only at the cost of insane austerity policy, the complete opposite of the needed European policy. Bullard goes further astray:

• Ordinary monetary policy provides or removes monetary accommodation in response to macroeconomic developments.
• There has been a large macroeconomic development in Europe: Eurozone recession.
• Yet, little direct action has been taken by the ECB in response to the recession.
• One could argue that the monetary policy response to the European recession has been muted compared to more ordinary circumstances.
• Why? By nearly all accounts, the monetary policy process has been bogged down by political wrangling over the OMT and other programs.

So Bullard is arguing that the ECB failed to focus on monetary policy, instead focusing on fiscal policy, and as a consequence Europe is in recession. But nothing prevented the ECB from enacting sane policy; fiscal authorities did not force them to raise interest rates. They chose poor policy time and time again by themselves. Indeed, I don't think Bullard shows any appreciation for the complexity of European economic policy. The ECB wasn't pulled into a role as fiscal policymakers as much as they were pulled into their role as monetary policymakers. The European experiment begins with major structural errors: A lack of fiscal authority, the central bank that does not believe that serving as a lender of last resort is within its mandate, and a bias toward fiscal austerity even in the face of deepening recession. The outcome was chaos. With no clear fiscal counterpart, standard analysis of central banks does not make any sense. Europe has simply been plagued by bad policy across the board.

Also, I am pretty sure that European central bankers will bristle at the implication that their response has been muted. Even I have to admit that they made great strides this year.

I am not even sure why Bullard went down the European road to begin with. The standard argument is that when fiscal policymakers encroach on monetary policy, the path of economic activity becomes unstable and inflationary. Europe is the case of monetary policy encroaching on fiscal policy. Why not take the more obvious example of the Bank of Japan, where monetary policy is looking poised to become a tool of fiscal policy?

In short, I find this to be a confusing speech. The title implies a threat to central bank independence, but he gives little reason to believe such a threat exists. The implementation of fiscal policy does not necessarily imply the lost of monetary independence. The monetary authority could still choose to lean against fiscal policy. That loss of independence would only be evident if monetary policymakers sustained an easy policy at the behest of fiscal policymakers in such a way that fostered higher inflation. Bullard gives no example of a monetary policymaker forced to act in such a way. Instead, he offers up the example of the ECB, which I would say has stripped fiscal policymakers of their independence, not vice-versa. Finally, he misses the obvious example of the potential loss of monetary independence, the Bank of Japan.

Cyberattacks on Banks Escalating

President of the Atlanta Fed, Dennis Lockhart:

...A real financial stabiliy concern ... is the potential for malicious disruptions to the payments system in the form of broadly targeted cyberattacks. Just in the last few months, the United States has experienced an escalating incidence of distributed denial of service attacks aimed at our largest banks. The attacks came simultaneously or in rapid succession. They appear to have been executed by sophisticated, well-organized hacking groups who flood bank web servers with junk data, allowing the hackers to target certain web applications and disrupt online services. Nearly all the perpetrators are external to the targeted organizations, and they appear to be operating from all over the globe. Their motives are not always clear. Some are in it for money, while others are in it for what you might call ideological or political reasons.

Unlike other cybercrime activity, which aims to steal customer data for the purpose of unauthorized transactions, distributed denial of service attacks do not necessarily result in stolen data. Rather, the intent appears to be to disable essential systems of financial institutions and cause them financial loss and reputational damage. The intent may be mischief on a grand scale, but also retaliation for matters not directly associated with the financial sector.

Banks have been defending themselves against cyberattacks for a while, but the recent attacks involved unprecedented volumes of traffic—up to 20 times more than in previous attacks. Banks and other participants in the payments system will need to reevaluate defense strategies. The increasing incidence and heightened magnitude of attacks suggests to me the need to update our thinking. What was previously classified as an unlikely but very damaging event affecting one or a few institutions should now probably be thought of as a persistent threat with potential systemic implications.

I'm drawing your attention to this area of risk... But I feel the need to be measured about the potential for severe financial instability from this source. In my judgment, cyberattacks on payments systems are not likely to have as deep or long lasting an impact on financial system stability as fiscal crises or bank runs, for example. Nonetheless, there is real justification for a call to action. ...

Even broad adoption of preventive measures may not thwart all attacks. Collaborative efforts should be oriented to building industry resilience. Resilience measures would be similar to those put in place in the banking industry to maintain operations in a natural disaster—multiple backup sites and redundant computer systems, for example.

Kocherlakota: Planning for Liftoff

[This is a pretend interview with Narayana Kocherlakota based on his speech today, Planning for Liftoff, laying out an exit strategy for the Fed.]

Hi. Good to see you again. What are you going to say in your speech?

In my remarks today, I’ll briefly discuss the objectives of the Federal Open Market Committee, or FOMC, which is the monetary policymaking arm of the Federal Reserve. Next, I’ll present a pictorial review of the evolution of macroeconomic data over the past five years.

With that background, I will then turn to a discussion of monetary policy. My jumping-off point is a phrase in the FOMC statement issued last Thursday. In that statement, the Committee said that it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” My main message today is that the FOMC can provide additional monetary stimulus by making this sentence more precise in the form of what I’m going to call a liftoff plan: a description of the economic conditions that would lead the Committee to contemplate the initial increase in the fed funds rate above its currently extraordinarily low level.²

So if I understand correctly, now that the Fed has eased further -- something I would not have expected you to support given your past remarks -- your main goal is to be clear about how soon the Fed can begin reversing policy? Your goal is to clarify the exit strategy?

I will suggest the following specific contingency plan for liftoff:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

The price stability part seems to be a bit of a catch. This appears to say that the Fed will only continue with stimulative policy so long as it is not worried about inflation. That doesn't seem much different from current policy, except it's dressed up with a few numbers and some bolded text. What's new here?

I’ll be much more precise later about the meaning of the phrase “satisfies its price stability mandate.” Briefly, though, I mean that longer-term inflation expectations are stable and that the Committee’s medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent. The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent.

Wait a minute. I asked you very specifically last spring why the Fed had an asymmetric aversion to inflation -- there seems to be much more tolerance of inflation below target than inflation above target. In fact, 2 percent inflation looks more like a hard ceiling for than a central value. At that time, you insisted that the Fed had a symmetric tolerance -- it was just as willing to tolerate inflation above target as below. Now you're telling us a hard ceiling of 2.25 percent is needed? How is that consistent with the symmetry you claimed in the past? 

Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

Thus, my proposed liftoff plan contains a specific definition of the phrase “a considerable time after the economic recovery strengthens.” In my talk, I will argue that this specificity—about an event that may not take place for four or more years—will provide needed current stimulus to the economy.

I'll listen closely when you get to that part. But can you explain a bit more now?

A key question is: How much leeway around 2 percent is appropriate?

The Committee has made no formal decision about this issue, and my own thinking continues to evolve. But I currently believe that allowing the medium-term outlook for inflation to deviate from 2 percent by a quarter of a percentage point in either direction would provide sufficient flexibility to the Committee, while posing no threat to the credibility of the long-run target. I’ll provide more details on my thinking about this issue later in the talk.

To sum up, the FOMC defines its price stability mandate as a 2 percent inflation target over the longer run. When operationalizing this definition, though, it is necessary to take into account the lags associated with monetary policy and to allow for some medium-term flexibility around the long-run target. Given these considerations, in my view, the FOMC can be said to be satisfying its price stability mandate as long as its medium-term outlook for inflation is between 1 3/4 percent and 2 1/4 percent, and longer-term inflation expectations remain stable.

So you basically have a hard 2 percent target, and only allow tolerance around that due to technical constraints that prevent tighter bounds? I suspect some people are going to think you have increased your tolerance for inflation, but you really haven't, have you?

Let's talk a bit more about your "liftoff" plan. Can you summarize how it works?

I think that it is safe to say that, relative to historical norms, the current stance of monetary policy is quite unusual. In June 2011, the FOMC released a statement describing its exit strategy—that is, the sequence of steps involved in returning monetary policy to a more normal stance. However, that 2011 statement said nothing about the conditions that would trigger the initiation of this exit strategy. This omission is problematic. The current economic impact of both forms of accommodation—low interest rates and asset purchases—depends on when the public believes that accommodation will be removed.

To understand this critical point, consider two possible scenarios. In the first, the public believes that the FOMC will initiate liftoff once the unemployment rate hits 7 percent. In the second, the public believes that the FOMC will defer initiation of liftoff until the unemployment rate hits 6 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity. In other words, the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.

So what is the specific plan?

The proposed plan is the following:

As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

As discussed earlier, by “satisfy its price stability mandate,” I mean that longer-term inflation expectations are stable, and the Committee’s outlook is that the annual inflation rate in two years will be within a quarter of a percentage point of the target inflation rate of 2 percent.

Why so much sensitivity to inflation? Why not, say, a 3 percent threshold instead?

Why is this liftoff plan an appropriate one? I argued earlier that the FOMC can provide more current stimulus by using a lower unemployment rate threshold for liftoff. Of course, additional monetary stimulus will give rise to more inflationary pressures, and those pressures are problematic because they could lead the FOMC to violate its price stability mandate. However, in my view, the Committee should choose the lowest unemployment rate threshold that it sees as unlikely to generate a violation of the price stability mandate.

This seems far too sensitive to inflation to me. Why such a low tolerance?

The proposed liftoff plan does allow the FOMC to contemplate raising the fed funds rate if the Committee’s medium-term inflation outlook rises above 2 1/4 percent. However, the following chart shows that recent historical evidence suggests that this possibility is unlikely to occur. It documents that the medium-term inflation outlook has not risen above 2 1/4 percent in the last 15 years.⁶ Thus, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, it seems unlikely that the price stability mandate would be violated.

I'm not asking about the likelihood of inflation rising above 2.25 percent, I'm asking why you have such intolerant bonds on the inflation rate.

The liftoff plan does not say that the Committee will raise the fed funds rate when the medium-term inflation outlook exceeds 2 1/4 percent—only that it could. The Committee’s decision in this context would hinge on a delicate cost-benefit calculation that would weigh the inflation increases against the employment gains. That policy conversation would, I conjecture, be a challenging one. Among other issues, it could well involve a reassessment of the long-run unemployment rate that is consistent with 2 percent inflation.⁷

So your policy, in a nutshell, is that the Fed should be accommodative, but if inflation rises above 2.25 percent, or threatens to do so, the Fed should have a serious talk?

In the same vein, the unemployment rate of 5.5 percent should be viewed as only a threshold to initiate a policy conversation, not as a trigger for action. For example, it is possible that macroeconomic shocks could lead the Committee’s medium-term outlook for inflation to be below 2 percent when the unemployment rate falls below 5.5 percent. At that point, the Committee might want to defer initiating exit, and the liftoff plan allows the Committee to consider doing so.

One thing I don't understand, how is this supposed to work if you won't allow inflation to rise above 2.25 percent -- basically the minimum technical tolerance associated with a hard 2 percent medium run target?

I want to be clear about the economic mechanism by which the proposed liftoff plan generates stimulus. First, it does not generate stimulus by having the FOMC tolerate higher rates of inflation, as has been espoused by many observers. I am doubtful about the efficacy of the inflation-based approach. I suspect that many households would believe that their wage increases would not keep up with the higher anticipated inflation rates. Those households would save more and spend less—exactly the opposite of the policy’s aim. In any event, I think that this approach is a risky one for central banks to use, because it requires them to raise inflation expectations—but not too much.

Thus, the liftoff plan that I’ve discussed only applies when the FOMC satisfies its price stability mandate. How then does the proposed liftoff plan generate stimulus? The plan recommends that the FOMC clearly communicate its intention to pursue policies that are fully supportive of much higher levels of economic activity. Thus, the plan commits to keeping the fed funds rate extraordinarily low until the unemployment rate is much nearer historical norms, as long as inflation remains under control. With that commitment, households can anticipate a lower path for unemployment, and they can save less to guard against the risk of job loss. People will spend more today, and that will drive up economic activity.⁸

So because it might end up as too much inflation, your answer is none at all? You're saying that some inflation would, in fact be useful, but one is too many and a hundred not enough? One taste of inflation, and it rips out of control? I have more faith in you and your colleagues than that. The Fed can allow inflation to, say, go to three percent without risking that it spirals out of control, I think, but you don't seem to have much faith in your colleagues.

You are likely to get a lot of credit for dropping your inflation hawkery, but I don't see it. The target is still 2% + min possible error of .25 percent, so I don't see that you've loosened much at all relative to the past (and even if the "min possible error" interpretation is incorrect, plus or minus .25 percent is hardly the definition of tolerant). You certainly have not embraced a transmission mechanism for policy that runs through elevated inflation expectations, the way most economists think these policies work. How would you respond to that?

I’ve spent much of my time describing what I see as an appropriate liftoff plan. I’ve proposed that, given current Committee thinking about the economy’s productive capacity, the Committee should plan on deferring exit until the unemployment rate falls below 5.5 percent. Critically, there are important inflation safeguards embedded in the plan: The Committee could consider initiating liftoff if its medium-term inflation outlook ever exceeds 2 1/4 percent. The evidence from the past 15 years suggests that this event is unlikely to occur.

President Charles Evans of the Federal Reserve Bank of Chicago has also proposed what I’m calling a liftoff plan. As I said last year in answer to a media query, I very much liked his approach to thinking about the problem. Those familiar with his plan will see that my thinking has been greatly influenced by his. This is perhaps hardly surprising, since he sits next to me at every FOMC meeting!

My building on President Evans’ creative proposal in this fashion is, I think, indicative of how the Federal Open Market Committee operates. The making of monetary policy under Chairman Ben Bernanke’s leadership is a distinctly collaborative process. Obviously, we don’t always agree with one another. It would be surprising if we did in such unusual economic conditions. But we learn continually from each other’s points of view. In that way, I believe that we can start to make progress on the challenging economic problems we face.

I hope you continue to sit by Evans, I sat by him not too long ago at a conference and I learned from him as well. You are still a ways from him -- you remain far more hawkish than he is, at least in my assessment -- but maybe, just maybe your views will continue to evolve towards his. One last thing. I know Jim Bullard respects you a lot, can you bring him along as well?

Perhaps not, but in any case, thanks for allowing me pretend I'm interviewing you.

Update: After posting this, I tweeted:

Pushback on previous post: Significance of Kockerlakota's speech is his changed view of structural vs. cyclical unemployment, not inflation.

Couldn't ask about that in pretend interview since he didn't say much about it in his speech.

But not so sure he's changed his mind, though he has allowed for the chance he's wrong. If it is structural, inflation will rise above 2.25 ... as QE proceeds, and he'll favor tightening even if unemployment > 5.5%. Only difference I see is that he isn't insisting it's structural ... as he was before. Perhaps the paper by Lazear at Jackson Hole raised some doubt.

The Case for More Monetary Accommodation

Charles Evans, president of the Chicago Fed, explains the Fed's recent decision to provide more accommodative monetary policy at the end of a speech he gave on Monday:

... The Case for More Accommodation ... Given the slow and fragile recovery, the large resource gaps that still exist, and the large risks we face, it remains clear that we needed a more resilient economy that can withstand the headwinds that might come its way. Last week the FOMC provided a more accommodative monetary policy that can help us achieve such resilience. I strongly supported the Committee’s policy actions. These actions, along with Chairman Bernanke’s powerful commentary that the employment situation remained a “grave concern,” moved quite a ways toward my preference for providing more explicit forward guidance with respect to monetary policy reactions to changes in labor market conditions.

In many venues over the past couple years I have laid out my preferred way to provide additional accommodation.[8] Specifically, I believe we should adopt an explicit state-contingent policy rule that commits the Fed to providing accommodation at least as long as the unemployment rate remains above 7 percent and the outlook for inflation over the medium term is under 3 percent. If our progress toward this unemployment marker falters, then we should expand our balance sheet to increase the degree of monetary support. Indeed, we took such an action last week. Note the importance of the inflation trigger — it is a safeguard against unacceptable outcomes with regard to price stability. I also believe we should be more explicit about what it means for the inflation target to be symmetric... Namely, symmetry means that the costs of an inflation rate above our 2 percent goal are the same as the costs of equal-sized miss in inflation below 2 percent. Its implication is that we should not be resistant to policies that could move the unemployment rate closer its longer-run level, but run the risk of inflation running only a few tenths above our 2 percent goal. Such accommodative polices could further improve the employment picture, even beyond our recent highly beneficial actions.

While our policy actions last week don’t exactly match my preferred policy structure, I support them wholeheartedly. Tying the period of time over which we will purchase assets to the achievement of significant improvement in the labor market is a strong step towards economic conditionality — that is, it conditions our actions to the economy’s performance instead of a calendar date. And stating that we expect to keep a highly accommodative stance for policy for a considerable time after the recovery strengthens is an important reassurance to households and businesses that Fed policy will not tighten prematurely. A large body of economic research says that committing to such a delay is a key feature of optimal policies during periods when policy rates are constrained to be zero, such as we have experienced in the U.S. since late 2008.

Conclusion

Let me be clear. This was the time to act. With the problems we face and the potential dangers lying ahead, it is essential to do as much as we can now to bolster the resiliency and vibrancy of the economy. We cannot be complacent and assume that the economy is not being damaged if no action is taken. I am optimistic that we can achieve better outcomes through more monetary policy accommodation.

Some have argued that the circumstances we find ourselves in today are so different from the way in which monetary policy normally operates that we must tread cautiously. They argue that more monetary policy accommodation may lead to unintended consequences. Yet, being timid and unduly passive can also lead to unintended consequences. If we continue to take only modest, cautious, safe policy actions, we risk suffering a lost decade similar to that which Japan experienced in the 1990s. Underestimating the enormity of our problems and the negative forces holding back growth itself exposes the economy to other potentially more serious unintended consequences. That type of passivity is a gamble that is not worth taking. Thank you.

Bernanke: Many Individuals and Households Continue to Struggle

Ben Bernanke earlier today:

...aggregate statistics can sometimes mask important information.  For example, even though some key aggregate metrics--including consumer spending, disposable income, household net worth, and debt service payments--have moved in the direction of recovery, it is clear that many individuals and households continue to struggle with difficult economic and financial conditions. Exclusive attention to aggregate numbers is likely to paint an incomplete picture of what many individuals are experiencing. One implication is that we should increase the attention paid to microeconomic data, which better capture the diversity of experience across households and firms. ...

Another implication is that policymakers such as Ben Bernanke should do more to help individuals and households who "continue to struggle with difficult economic and financial conditions." So why isn't he pushing the Fed to do more at every opportunity?

Ben Bernanke and the Washington Consensus

A few quick and somewhat scattered comments on Bernanke's speech today:

Ben Bernanke and the Washington Consensus

Bernanke: Raise the Debt Ceiling

One more at MoneyWatch:

Bernanke: Raise the Debt Ceiling

It's a reaction to Bernanke's speech today discussing both budget deficits and the debt ceiling.

Grep Ip: Read This Speech, Then Sell the Dollar

Greg Ip at The Economist:

Read this speech, then sell the dollar, The Economist: Ben Bernanke's speech on Tuesday got all the attention, but the speech later that day by Bill Dudley, head of the New York Fed, is more intriguing. In it he analyses the macroeconomic origins of the global imbalances that precipitated the crisis and prescribes the policy path forward....

In a nutshell, Mr Dudley tells us that aggressively easy monetary policy is essential to both the cyclical recovery and to a structural rebalancing of the American economy away from consumption and toward exports. This process will go more smoothly for everyone if emerging market economies (EMEs) cooperate and let their exchange rates appreciate (i.e. let the dollar fall), but absent such cooperation, don’t expect the Fed to change course. ...

EMEs have complained loudly that easy American monetary policy has fueled destabilizing flows of capital into their economies, driving their currencies up and the dollar down. That, Mr Dudley (uncharacteristically for the Fed) admits  “is at least possible” but then, in effect, tells them to deal with it...

Not surprisingly, Mr Dudley would like the EMEs and the rich world to cooperatively “move toward arrangements that put us on a mutually sustainable path”. This, obviously, means the EMEs allowing the dollar to fall further against their currencies. Mr Dudley does not, however, answer the question on everyone’s mind. Given the economy’s latest soft patch, is the Fed prepared to force the issue with more QE? ...

It may not matter. As William Pesek over at Bloomberg observes, Asian currencies are already reacting as if QE3 is on its way;... it is ... possible that Fed is getting its way with words, such as Mr Dudley’s speech, as much as with actions.

Bernanke’s Speech: How Does Quantitative Easing Work? Will It Work?

I agree with Brad DeLong's reaction to Ben Bernanke's speech:

Ben Bernanke's Speech Was... Disappointing, by Brad DeLong: I am still surprised at the Fed Chair we have. Where is the Fed Chair who was willing to try to get ahead of the problems in late 2008? Or the "Helicopter Ben" of 2003? Or the student of big downturns in Japan in the 1990s and the U.S. in the 1930s.

It's a very different animal we have today. And this speech didn't do much to convince me that he is going to do what ought to be done.

Bernanke forecasts that growth next year "seems unlikely to be much above its longer-term trend"--that is, that unemployment is likely to rise in the near term and then stay essentially stable through the end of 2011 before it even starts to think about heading down.

In this environment, now is not the time for Bernanke to talk about the costs and risks of expanding the Federal Reserve balance sheet.

And it is also not the time to talk about how monetary policy can be carried out via the Federal Reserve's communications strategy.

Since I have been fairly skeptical of how much this can help the economy --  don't expect it to have a large impact on its own -- let me outline the channels through which this might work:

1. By reducing the quantity of financial assets trading in the private sector, the Fed can lower the rate of return on these assets (which is the same as raising the price of the assets since the price of a financial asset and the interest return are inversely related). The fall in the interest rate creates an incentive for more investment and more consumption of durables, which in turn increases o0utput and employment.

2. Quantitative easing may increase expected inflation. The increase in expected inflation lowers the real interest rate (the real interest rate = nominal interest rate - the expecte4d rate of inflation). The fall in the real interest rate would have the effects outlined above, i.e. create an incentive for more investment and consumption of durables, which then spurs output and employment.

3. The increase in the price of the financial asset due to the inverse relationship between the price and the rate of return noted above. This makes people feel wealthier, and the wealth effect can spur more spending generating an increase in output and employment.

4. The Fed can also lower the risk premia on financial assets, which is another way of lowering the interest rate. Though I don't expect them to do this, the Fed could buy highly risky private sector financial assets, thereby moving them off private sector balance sheets and onto the government's. With fewer risky assets in the marketplace, average risk falls driving down interest rates, and that would, once again, have the effects on consumption, investment, output, and employment described above.

5. [update] It can also cause the dollar to weaken, i.e. change the exchange rate, which would encourage exports and discourage imports (though this assumes that other countries don't respond and offset the fall in the exchange rate).

As I said many times, I don't expect any of these to have particularly powerful effects, they create incentives for businesses and consumers to increase spending, but there's no guarantee that they will act on those incentives given the negative outlook for the economy (so fiscal policy authorities should not assume that the Fed "has this"). Again, as I've said before, you can lead the horse to low interest rate water, but there's no guarantee it will drink consumption and investment. In addition, as Brad notes, it's not clear that the size of the quantitative easing will be sufficient. However, in combination the factors listed above could, perhaps, be helpful. It's certainly better than doing nothing.

[Dual posted at MoneyWatch.]

"Bernanke Breaks Promise, Discusses Fiscal Issues"

CR is blunt:

Bernanke breaks promise, discusses fiscal issues, by Calulated Risk: This speech isn't worth reading for substance (Ben Bernanke is clueless on budget issues), but it reveals something about Bernanke.

From Fed Chairman Ben Bernanke speaking at the Rhode Island Public Expenditure Council meeting tonight: Fiscal Sustainability and Fiscal Rules

Bernanke never mentioned "PAYGO" when he was head of the Council of Economic Advisors in 2005. In fact Bernanke barely mentioned the deficit in 2005 - except in postive terms - even though the structural deficit was in place and the cyclical deficit was coming (because of the housing bubble). I wonder why? Well, he missed the housing bubble completely - but what about the structural deficit?

Today he said:

Our fiscal challenges are especially daunting because they are mostly the product of powerful underlying trends, not short-term or temporary factors. Two of the most important driving forces are the aging of the U.S. population, the pace of which will intensify over the next couple of decades as the baby-boom generation retires, and rapidly rising health-care costs.

Weren't the baby boomers going to get older in 2005? Oh my ...

This is an issue that 1) is outside of Bernanke's area of responsibility, 2) he has promised not to discuss, and 3) he has zero credibility on. Enough said.

On fiscal policy issues, I believe Bernanke should explain the choices the Fed would face under various fiscal scenarios, and how the Fed would be likely to react -- that's information Congress and the president need to make informed fiscal choices. But he shouldn't recommend one budget path over the other except as it affects monetary policy choices (search the speech for "money" or "monetary" and see how many times they come up, or try "inflation" -- try to find anything at all in the speech about the consequences of the current projected budget path for monetary policy). And he certainly shouldn't be trying to dictate how a particular budget choice should be achieved (e.g. he identifies "a top priority" that includes reduced "government health spending"). Why politicize the Fed unnecessarily by talking using examples such as changing the retirement age for Social Security -- people might wonder why you didn't choose to mention, say, raising the income cap instead -- especially at a time like now when the Fed has a critical role to play in the economy?

"A Perspective on the Future of U.S. Monetary Policy"

Charles Evans, President of the Federal Reserve bank of Chicago:

A Perspective on the Future of U.S. Monetary Policy, by Charles Evans, FRB Chicago: ...I think we face two key issues in the near and medium term. First, to what extent do structural factors explain the very high unemployment rate we currently have? Some have suggested that the financial crisis and the accompanying recession precipitated a seismic shift in the structure of labor markets, raising the natural rate of unemployment significantly above its pre-crisis level. If, as they suggest, labor market frictions rose dramatically over the past two years, then monetary policy is not the appropriate tool to address the ramifications of such a change. If, on the other hand, structural factors can only explain a modest part of the rapid rise in the unemployment rate, and aggregate demand deficiencies account for remainder, then monetary policy may be able to play a constructive role.

This brings me to the second key issue facing policymakers. If further monetary policy accommodation is desirable, what is the appropriate policy action when short-term interest rates are already at zero? Has extreme risk aversion by businesses and consumers put us in what can be described as a liquidity trap? And if so, what can we do about it?

Let me first elaborate on the unsatisfactory progress in employment gains, and what it implies for monetary policy. There are several reasons to think that the natural rate of unemployment has risen over the last couple of years. It is possible that the extension of unemployment insurance benefits during the recession, while cushioning unemployed workers from the adverse effects of lost income, might have reduced some workers’ job search intensity, or kept others from leaving the labor force. To the extent that such incentives are present, the natural rate of unemployment would increase while the extended benefits are in effect. However, reasonable estimates of the effect of the extension of unemployment benefits range one-half to one percentage points – far from sufficient to explain the nearly 5 percentage point increase over the past two years. Moreover, given the current schedule for the expiration of these benefits, the resulting increase in the natural unemployment rate will fade away over the next two years – leaving us still with an unsatisfactorily high rate of unemployment at the end of my forecast horizon.

It is also possible that the shocks that reverberated through the economy created a mismatch between the skills sought by employers and the skills the unemployed workers have. For instance, it is conceivable that the recession affected the different regions and sectors of the economy unevenly. Moreover, the recession may have severed an unusually large number of long-term employment relationships, making for an especially difficult transition for affected workers. The unusually long spells of unemployment experienced during the recent recession and potential erosion of skills during that time are additional factors that might have magnified labor market frictions. The sharp decline in home values and tight credit conditions might have reduced the ability of unemployed workers to sell their homes and move to regions where jobs are available. Taken together, these developments might have eroded the efficiency of matching between workers and jobs, and raised the natural rate of unemployment.[1]

The key question is: Are these possible structural changes in the labor market sufficient to explain the current unemployment rate? The Beveridge curve that describes the relationship between the unemployment rate and the job vacancy rate is a useful tool for addressing this question. The unemployment-vacancy relationship through the end of 2009 is captured very well by a simple, stable Beveridge curve and a constant-returns Cobb-Douglas matching function. So, the relationship between job openings and unemployment through the end of 2009 has been relatively stable, and does not suggest a dramatic increase in labor market frictions. It is only recently that we have seen an improvement in job openings that was not matched by a correspondingly large reduction in unemployment. Based on these data, some have suggested that most of the increase in the unemployment rate over the past two years is due to skills mismatch.

However, it seems likely that much of the apparent conflict between unemployment and vacancy data may be purely an issue of timing. At this stage of an economic recovery, it is not unusual for the vacancy rate to increase ahead of reductions in the unemployment rate – we have often seen such loops in the Beveridge curve at the end of past recessions.

But even if we take the job openings data at face value, it doesn’t suggest an increase in the natural rate to anything like the current rate of unemployment, which stands at 9.6 percent. Making some plausible assumptions, my staff estimates that the typical level of unemployment associated with a stable Beveridge curve passing through the recent data is likely to be about 7 percent. This includes the effects of increased unemployment insurance benefits that I already discussed.[2] 

I am not suggesting that 7 percent is a good estimate of the current natural rate. As I said, there are reasons to discount some of the recent improvement in the vacancy data. Rather, I want to point to out that, even if one takes the vacancy data at face value and accepts that the natural rate has risen to 7 percent, we are still left with a very large amount of slack relative to the current rate of unemployment and the rate most analysts expect to see at the end of 2012.[3]

The size of the unemployment gap, combined with the fact that inflation has been running below the level I consider consistent with long-term price stability, suggests that it would be desirable to increase monetary policy accommodation to boost aggregate demand and achieve our dual mandate.

Should the FOMC judge that further monetary policy accommodation is appropriate based on our economic outlook, what is the optimal level of additional accommodation and what policy tools should be employed to deliver the additional stimulus?

During a typical period of policy accommodation, the answers to these questions would be straightforward. The FOMC would lower the target federal funds rate based on our economic outlook and the historical relationship between policy actions and their impact on the economy. For instance, were the current fed funds rate at 3 percent, my forecast would call for a substantial decline in the target rate. Such a reduction in the nominal fed funds rate would be consistent with several versions of the Taylor rule, which would call for negative interest rates.[4] However, at roughly zero, the fed funds rate is as low as it can go.

As a result, the current economic environment poses unusual challenges to policymakers. In assessing the current state of the economy and considering the optimal policy response, a key issue that concerns me is the possibility that we might be in a liquidity trap.

As I assess the incoming data and talk to my business contacts, I see that executives are very cautious in their outlook and spending plans. They appear to be content to post strong profits generated by unprecedented cost-cutting, rather than growing their top-line revenues by expanding capital investments and hiring. Very conservative attitudes reign and cash is still king – even after the improvements in financial markets and strong bond issuance by businesses. Firms are sitting on the cash generated by profits and funds raised in capital markets. Very few are planning to grow their workforce. Although some contacts point to uncertainties raised by regulatory actions and government policies to explain their reluctance to invest, most admit that they would increase spending if stronger demand conditions prevailed.

Households are similarly cautious and gun-shy in their spending. Given the millions of jobs lost during the recession, the job insecurity faced by those employed, trillions of dollars in lost wealth and the balance-sheet repair that households have undertaken, consumers are displaying significant risk aversion. They have raised their savings rate, even though those savings earn very little interest income.

These are the classic symptoms associated with a liquidity trap: the supply of savings that outstrip the demand for investment even when short-term nominal rates are at zero.

The modern economic theory of liquidity traps indicates that the optimal policy response at zero-bound is to lower the real interest rate, almost surely by employing unconventional policy tools. Theory also indicates that, in the absence of such policy stimulus, the factors that generate high risk aversion could very well stifle a meaningful recovery, keep unemployment high and reinforce disinflationary pressures – clearly an undesirable equilibrium.

So, in the coming weeks and months, as I assess the incoming data, update my forecast and deliberate on the best monetary policy approach, I will be pondering two key issues: How much more should monetary policy do to reduce the shortfalls in meeting our dual mandate responsibilities for employment and price stability; and what tools should we use? Thank you.

I mostly agree with this analysis, but I am still left wondering how much demand can be increased with monetary policy tools. As I've said many times, I am convinced the Fed can bring down long-term interest rates, what I am uncertain about is how strong the reaction to this incentive will be. Lowering the real interest rate creates an incentive for firms to invest more, and for households to purchase more consumer durables, but how much consumption and investment will actually increase as a result of the fall in the real interest rate is an open question. Given the amount of excess capacity that exists, the poor outlook for the future for both firms and labor, the amount of cash firms are sitting on already, etc., etc., it's not at all clear to me that the response to a relatively small decline in real interest rates will be very strong. We can lead the horse to the low interest rate water, but will it drink more consumption and investment? To the extent that we can get something out of monetary policy, great, let's give it a shot -- I'm not worried about inflation -- but monetary policy by itself isn't enough.

That's why I think the demand shock needs to come from the fiscal side rather than the monetary side, and why -- to repeat another longstanding complaint -- I've been disappointed that people have focused so much on the Fed and let Congress off the hook. As the midterms approach, there has been hardly any effort to make the case that Congress should take a large share of the blame for the shape that the economy is in, particularly the shape of employment markets, all we are hearing about is the Fed, and it's disappointing to think that politicians will escape responsibility for their failure to provide people the help that they need.

"The Dramatic Jump in the Actual Unemployment Rate [is] Largely a Cyclical Phenomenon"

Minnesota Fed president Narayana Kocherlakota says once again that there's little that monetary policy can do for the unemployment problem because it's largely structural (here's Brad DeLong's reaction, see here too). However, researchers at the Cleveland Fed say their estimates tell a different story:

The dramatic jump in the actual unemployment rate we have observed since the beginning of the recession is being interpreted in our flows-based analysis as largely a cyclical phenomenon, with little movement in the long-term rate. The long-run trend does appear to have increased from its prerecession level, but by only a small margin.

The natural rate of unemployment is not 9.6 percent, the current unemployment rate. It's not even close to that (the Cleveland Fed says it's "roughly 5.6 percent to 5.7 percent"). But even if it was as high as 7.5 percent (to be clear, this is a hypothetical), are we just going to give up on the other 2.1 percent? I think that the cyclical component is a lot larger than 2.1 percent, and that even if there is a sizable structural problem there are still things we can do to help the structural transition along, including using low long-term interest rates to encourage the investment that helps that structural change happen faster. But even if you think the natural rate has increased quite a bit, and there's nothing the Fed can do for the structurally unemployed, it hasn't gone up as high as 9.6% and there's no reason to give up on those who can be helped.

And they do need help. As the Cleveland Fed notes in the link given above, even though the problem is largely cyclical in their view, it's looking like a long recovery is ahead:

Since we have not seen a big rise in the long-term unemployment rate, we might expect to converge to this “natural” rate soon. Unfortunately, this is not likely to be the case, and there are several reasons to suspect that the adjustment might take a long time. The first is the sheer extent of the gap between the current and long-term unemployment rates, regardless of the specific long-term rate one believes holds (figure 6). ... When the U.S. economy experienced a similar-size gap after the 1981–1982 recession, it took several years for the observed unemployment rate to drop to levels closer to the trend.

And it might be even harder for the labor market to adjust this time around. The rate of adjustment depends on how fast workers are reallocated between unemployment and the available jobs. The slower rates of worker reallocation we have found may act to slow the closing of the unemployment gap.

There are other reasons to believe that unemployment rates may stay well above the long-term rate for an extended period of time. Because of the length of the recession, there is a considerable number of potential workers who are not formally in the labor force. We have seen one of the sharpest drops in the labor force participation rate in the postwar data, as many unemployed workers simply stopped looking for a job. If some of these discouraged workers decide to search for a job as aggregate economic activity picks up, unemployment might decline at an even slower rate because the pool of unemployed workers is being replenished with workers re-entering the labor force.

Another concern raised by our findings is the negative impact of long-term unemployment on the human capital of the workforce. Longer unemployment spells are a problem because unemployed workers who are unemployed for too long can lose industry- and job-specific skills. Losing skills can reduce their odds of finding a job during the recovery as well as lower their productivity when they finally do find one.

Ultimately, an increase in the demand for labor will determine how fast the unemployment stock will be depleted. ...

Continuing the last point, we are simply not doing enough to create the labor demand that is needed. And, unfortunately, the claim that the problem is almost all structural and therefore there's little we can do is one of the things standing in the way of giving labor markets the help that they need.

"Optimism…Pessimism…and a Bit of Perspective"

Dennis Lockhart, president of the Atlanta Fed, makes it clear that presently he sees no need for more stimulus -- a slow, plodding recovery like we had in the previous two recession is the best we can expect. If we're on track to match those, there's no need to try to do better.

Here's David Altig of the Atlanta Fed discussing Lockhart's speech earlier today:

Optimism…pessimism…and a bit of perspective, by David Altig, macroblog: Here's how I'm tempted to summarize today's release of the August employment report from the U.S. Bureau of Labor Statistics: more of the same. That theme fits nicely with comments this morning from Atlanta Fed President Dennis Lockhart, in a speech at East Tennessee State University. Here he calls for a little perspective:

"Some commentators are reading recent economic data as suggesting the onset of a second recession and deflationary cycle. Quite naturally, business people and consumers aren't sure what to believe.

"At the last meeting of the Federal Open Market Committee (FOMC) in Washington, the committee made a decision that has been widely interpreted as signaling declining confidence in the strength and sustainability of the recovery….

"In my remarks today, I will provide a less alarmist interpretation of recent economic information and the Fed's recent policy decision. I will argue that, generally speaking, there was too much optimism in the early months and quarters of the recovery and now there may be excessive pessimism."

One point is that recoveries are not generally linear affairs:

"Growth at the end of last year and early part of this year was stronger than I anticipated while economic activity in the second and third quarters seems weaker than I expected.

"But such ups and downs are not unusual during a recovery. A little history: following the 2001 recession, gross domestic product (GDP) grew at the annualized rate of 3.5 percent in early 2002. Growth then decelerated to about 2 percent for the next two quarters then fell to almost zero in the fourth quarter. Entering 2003, growth edged up to a little over 1.5 percent and then accelerated from there to a sustained period of relatively strong growth for two years."

...Even in the rapid-growth, pre-1990 recoveries, there was generally a quarter or two of growth that underperformed. ...

But the better benchmarks will likely prove to be the slower-growth, low-employment recoveries post-1990. In addition to the 2001 experience noted by President Lockhart, the expansion that followed the 1990–91 recession stumbled along with quarterly growth rates of 2.7, 1.69, and 1.58 percent, before picking up to above-potential growth rates. Despite that, the eighth quarter after that recession's end clocked in at an anemic 0.75 percent.

So why are we content to match that performance instead of trying to improve? Why do we try to rationalize concerns instead (calling it "a bit of perspective")?:

What is more important is that there is a reasonably good explanation for why we might have hit a soft patch:

"Looking at the 2009–2010 recovery, it seems clear that some of the early strength was promoted by policies that pulled forward spending from the second and third quarters of this year. The recent sharp decline in housing-related indicators following the expiration of homebuyer tax credits is the most obvious example of this effect."

Given that expectation, wouldn't it have been nice to have someone, the Fed say, try to fill this hole until the private sector begins growing robustly on its own?

Back to David Altig:

Essentially, President Lockhart's is a simple message: don't ignore the short-term data, but be careful with getting too carried away with it as well.

"Simply stated, I was expecting a relatively modest recovery...

And he, along with other members of the Fed, is apparently content with that. Finally:

...with respect to that meeting, here is the main policy point:

"At the last meeting there were two important considerations as I saw it. First, as already discussed, some economic data came in weaker than expected, shifting the balance of risks to slower growth in the near term and further disinflation. Second, the Fed's holdings of MBS were projected to decline faster than previously thought because lower rates were generating heavy mortgage prepayments and refinancings.

"So, in the context of a softening economy, the FOMC was confronted with the prospect of unintended withdrawal of support for the recovery through a decline in the level of liquidity provided to the economy….

"That is how I interpret the decision announced following the August meeting—a small tactical change designed to preserve the level of liquidity provided to the system. I supported the committee's decision, but I do not view it as a fundamental change of outlook or strategy. I do not believe this change necessarily heralds the beginning of a period of further expansion of the Fed's balance sheet. Nor do I think the decision precludes a return to a policy of allowing the balance sheet to shrink on its own.

"I think the decision has been over-interpreted in some quarters."

...

So, again, the recovery is expected to plod along like we've seen in the past, at least that's the hope, and though the downside risk has increased and the Fed has the tools to try to help, it doesn't think it should use them.

My view is different.

The Fed’s Wait and See Policy is a Mistake

My reaction to Bernanke's speech:

The Fed’s Wait and See Policy is a Mistake

What would you add?

Jaws are Dropping

Minnesota Fed President Narayana Kocherlakota recently argued that low interest rates will eventually cause inflation deflation (sorry for the typo, it's hard to write the wrong answer). I'm trying to understand why people at the Fed are so reluctant to do more to help the economy, what the reasoning is, etc., but I have to meet a deadline and need to stop using the blog as a distraction. So let me just note that there is a lot of "jaw dropping" over Kocherlakota's claim. See, for example, Andy Harless, Nick Rowe, and Robert Waldmann.  [Please see the update to this post.]

Bernanke: In the Long-Run, We’re All on Social Security, Medicare

[From the airport...] Ben Bernanke is worried about entitlement programs:

Bernanke on Deficits: In Long Run, We’re All on Social Security, Medicare, RTE: This morning Jon Hilsenrath noted the Fed Chairman Ben Bernanke was likely to highlight the importance of deficit reduction in a series of speeches. The following is an excerpt on the issue from the chairman’s remarks in Dallas today:

The economist John Maynard Keynes said that in the long run, we are all dead. If he were around today he might say that, in the long run, we are all on Social Security and Medicare. That brings me to two interrelated economic challenges our nation faces: meeting the economic needs of an aging population and regaining fiscal sustainability. The U.S. population will change significantly in coming decades with the combined effect of the decline in fertility rates following the baby boom and increasing longevity. As our population ages, the ratio of working-age Americans to older Americans will fall, which could hold back the long-run prospects for living standards in our country. The aging of the population also will have a major impact on the federal budget, most dramatically on the Social Security and Medicare programs, particularly if the cost of health care continues to rise at its historical rate. Thus, we must begin now to prepare for this coming demographic transition.

The economist Herb Stein once famously said, “If something cannot go on forever, it will stop.” That adage certainly applies to our nation’s fiscal situation. Inevitably, addressing the fiscal challenges posed by an aging population will require a willingness to make difficult choices. The arithmetic is, unfortunately, quite clear. To avoid large and unsustainable budget deficits, the nation will ultimately have to choose among higher taxes, modifications to entitlement programs such as Social Security and Medicare, less spending on everything else from education to defense, or some combination of the above. These choices are difficult, and it always seems easier to put them off–until the day they cannot be put off any more. But unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth.

Today the economy continues to operate well below its potential, which implies that a sharp near-term reduction in our fiscal deficit is probably neither practical nor advisable. However, nothing prevents us from beginning now to develop a credible plan for meeting our long-run fiscal challenges. Indeed, a credible plan that demonstrated a commitment to achieving long-run fiscal sustainability could lead to lower interest rates and more rapid growth in the near term.

Our economic challenges, both near term and longer term, are daunting indeed. Nonetheless, I remain optimistic that they can be met. ...

The CBO has argued persuasively (scroll down) that demographics is not the main problem:

In addition, Social Security can be fixed relatively easy. It is health care costs rising independent of the aging of the population that must be addressed.

But there may be a solution:

Delayed retirement among Americans may bolster future of Social Security and Medicare, EurekAlert: An unprecedented upturn in the number of older Americans who delay retirement is likely to continue and even accelerate over the next two decades, a trend that should help ease the financial challenges facing both Social Security and Medicare, according to a new RAND Corporation study.

While government projections suggest the number of older Americans who remain employed is likely to plateau over the coming decade, RAND researchers say a more likely scenario is that the increase in delaying retirement that began in the late 1990s is likely to gain speed.

Because the trend holds broad benefits for the nation, lawmakers may want to consider reforms that would dismantle barriers that discourage some older people from remaining employed and even consider changes that would encourage employers to hire older workers. ...

In a report published in the Journal of Economic Perspectives, RAND researchers examine a wide array of evidence that suggests that delayed retirement or partial retirement are likely to increase...

A principal reason why retirement rates have dropped is because of an evolution in the skill composition of the nation's workforce, according to the study. As American workers have gained more education, they have achieved jobs that are more fulfilling, they face fewer physical demands in the workplace and they are paid more for their efforts.

Adding to this phenomenon is the rise in the number of dual-earner families. Since couples tend to retire together and men often are older than their spouse, men may stay in the work force longer to accommodate their wives' work lives, according to the study.

While there have been several changes made to Social Security that encourage people to work longer, researchers say those changes appear to be a secondary force behind the trend observed thus far. ...

Additional incentives are on the horizon that may fuel the future growth of the number of older Americans delaying retirement.

Changes to Social Security that delay full benefits from age 65 to age 67 will not be fully in force until 2022, and there have been discussions about further extending the threshold as well. In addition, as labor force participation among younger women has risen over time, women have become increasingly likely to qualify for Social Security benefits on their own work record. As a result, women now more than ever face direct incentives to extend their work lives in order to qualify for higher benefits.

In addition, as people live longer more Americans may need to extend their work lives to accumulate wealth to provide for their needs during old age.

Researchers say that lawmakers may want to consider policies that would further aid older Americans who want to delay retirement. Such measures include eliminating measures in some pension plans that penalize recipients who continue working and improving the public's understanding of retirement and pension rules. ...

Though they downplay it a bit, bad economic policy that creates lots of uncertainty -- something Congress is expert at -- extends their working lives. That's not a recommendation, just an observation.

"Prospects for Sustained Recovery and Employment Gains"

I'm encouraged that at least one Federal Reserve policymaker (though not a voting member of the FOMC) is linking increases in the target federal funds rate, i.e. moving away from a zero interest rate policy, to improvements in the labor market. However, if expected inflation begins increasing, all bets are off.

That's the part that concerns me. How quickly will policymakers abandon efforts to stimulate employment by maintaining a zero interest rate policy if they start to get worried about inflation? What, exactly, is the tradeoff here? Will any sign of inflation whatsoever cause policymakers to panic and start aggressively raising interest rates even if unemployment remains elevated, or will concerns over employment cause them to be patient and accept some inflation in the short-run? Again, it's encouraging that employment concerns are coming to the forefront of the policy decision, but will those concerns carry sufficient weight if there are signs that inflation expectations are increasing? I'm worried that they won't:

Prospects for Sustained Recovery and Employment Gains, by Dennis P. Lockhart, President and Chief Executive Officer, Federal Reserve Bank of Atlanta: After the deepest and longest recession in the past half century ... the U.S. economy is now in recovery. Today I want to discuss the prospects that the recovery ... is sustainable—and the implications ... for perhaps the most vexing current problem coming out of the recession: unemployment. ...

The economy remains in a transitional phase from a period that depended on support of public sector programs to a period of resumed growth based on private spending. For the recovery to be sustained, we need consumers to consume and businesses to spend on inventory, investment goods, and human resources. Economic forecasts hinge on how formidable those positive forces will be and on the strength of countervailing headwinds.

Views about the economic outlook fall roughly into two narratives. The more optimistic scenario is a V-shaped bounce back from severe recession. ... By contrast, the second scenario is a relatively modest recovery, with slow reduction of unemployment. ... In ... Atlanta..., our outlook is closer to the second narrative.

Perspective on labor markets
As already suggested, an implication of this slow recovery scenario is the very gradual decline of today's unacceptably high rate of unemployment. ... Today, the rate stands at 9.7 percent, down from a high of more than 10 percent in October.

I view unemployment as a daunting economic challenge—and very likely a dominant political issue—of the period ahead. ... Today, there are about 130 million payroll jobs in the United States, and that number is about 8.4 million lower than at the beginning of the recession. ...

About 15 million people in the United States are unemployed. ... Also, underemployment is prevalent. The underemployed include both discouraged workers...  as well as individuals who are working part-time but want to work full-time. The unemployment rate that combines the fully unemployed and underemployed workers is about 17 percent.

Another indication of underemployment is reduced hours of work. Average hours of work per week are still well below prerecession levels...

Despite the weak state of labor markets, there are signs that the worst may be behind us. The rate of job loss is slowing. The rate of decline in payroll employment has been close to zero in the last couple of months. Also, while initial and continuing unemployment claims are at historically high levels, both have fallen.

Another bright spot is temporary employment. The temporary services sector shed more than 800,000 jobs during the recession but has seen a notable increase since last fall. This improvement is noteworthy as temporary employment is often viewed as a leading indicator.

The normal state of affairs in the country's labor market is a dynamic mix of separations from employment and new job creation. There are two causes of separations—layoffs and voluntarily quitting a job, or so-called quits. ... Today's slow pace of employment gains is due more to the slow pace of job creation, not the high rate of layoffs.

Job gains, as conventionally understood, require two things: a vacancy and a worker able to fill that vacancy. For most of 2009, vacancies were relatively flat while unemployment continued to rise. This condition suggests the existence of what labor economists call "match inefficiencies."

There are two key types of match inefficiency. One is geographic mismatch. In 2008, the percentage of individuals living in a county or state different than the previous year was the lowest recorded in more than 50 years of data. People may be reluctant to relocate for a new job if the value of their house has declined. In addition, many who would like to move are under water in their mortgage or can't sell their homes.

The second inefficiency is skills mismatch. In simple terms, the skills people have don't match the jobs available. Coming out of this recession there may be a more or less permanent change in the composition of jobs. Skill mismatches require new training, and there is evidence that adult education institutions have responded to this need. For instance, officials at Miami-Dade College in Florida, which is the largest college in the country and a grantor of associate and vocational degrees, told us they have recently seen a strong increase in enrollment, especially of men in their 20s.

This evidence of retooling is encouraging, but, to be realistic, structural adjustment takes time. ...

All things considered, labor market trends appear to be headed in the right direction. But it's quite possible the recovery could be well advanced before any significant reduction of unemployment materializes. It's also quite possible circumstances justifying the start of a cycle of policy tightening will develop well before the unemployment rate has found a satisfactory level. ... So let me now comment on how I'm thinking about the relationship between the Fed's employment mandate and monetary policy.

Implications for monetary policy
As you know, monetary policy is highly accommodative. And I think this stance is appropriate at present. I continue to support ... a low federal funds rate target for an extended period. ... As long as inflation remains subdued and inflation expectations anchored, a key factor for me is improvement of employment markets.

Going forward, I will be looking for signs that employment gains are likely to repeat and accumulate and, once achieved, are likely to be durable.

What might such signs be? One indication would be that the process of job creation is improving. In January, we saw a sizable increase of job openings, according to the BLS. I'm looking for that to become a trend. A second sign would be a decline in the measured rate of underemployment. And the third sign would be a string of employment gains large enough to appreciably move the unemployment rate down over time.

There are hopeful, if tentative, signs of improvement in employment markets. We have a long way to go, and for that reason I believe it is premature to assume an imminent reversal of the Fed's accommodative policy. But you can interpret the fact that I am here discussing the conditions under which such a reversal will be appropriate as an indication of my conviction that we are, finally, moving in the right direction.

Monetary Policy and Unemployment: Should the Fed have Done More?

Should the Fed have done more to combat the unemployment problem? In examining the costs and benefits of further easing, I have made almost all of the arguments against further easing by the Fed made below, i.e. that further easing by the Fed may not have much additional effect on long-term real interest rates, that even if rates could be brought down, consumers and businesses would be unlikely to respond by increasing investment and the consumption of durables -- firms already have considerable idle capacity, so why build more, and consumers are pessimistic about their futures, so why buy on credit -- and that there is an inflation risk from further easing.

One additional argument against more aggressive action by the Fed is that there is considerable uncertainty about the effects of further easing because they do not yet have "a robust suite of formal models to reliably calibrate interventions of this sort." But as with climate change, uncertainty does not necessarily translate into inaction. If the uncertainty includes much worse outcomes for employment than expected, and if the costs we attach to that outcome are very large, then uncertainty may prompt more aggressive rather than less aggressive intervention.

Yet another argument concerns the degree to which current productivity changes are permanent of temporary and how that translates into the degree of slack in labor markets. However, on this point I agree that "the sheer magnitude of unemployment today is so large that there is little doubt in my mind that there is considerable slack in the economy." Thus, however this debate comes out, it does not much change the degree and urgency of the unemployment problem.

In the end it comes down to the relative weights placed on the cost of inflation and the cost of unemployment, and I don't think policymakers are placing enough weight on the unemployment term (particularly given the uncertainty about the speed of recovery).

The Fed has the ability to help -- something needs to be done -- and a responsibility to help to the unemployed. The Fed is not alone in not doing enough, fiscal policymakers bear even more responsibility for failing to act aggressively, but that doesn't excuse the Fed's less than full bore attack on the unemployment problem.

This is the last part of a speech given today from Charlie Evans, President of the Chicago Fed, along with a graph from the speech showing the severity of the long-term unemployment problem:

Labor Markets and Monetary Policy, by Charles Evans, President, Chicago Fed: ...Productivity and resource slack The other side of an economy experiencing growing output but low labor utilization is high productivity growth. Indeed, productivity has been quite strong of late, particularly over the past three quarters. This is often the case in the early stages of a recovery, as firms first meet higher demand for their products and services without expanding their work force.

A key question today is the degree to which the recent productivity surge reflects a temporary cyclical development or a more enduring increase in the level or trend rate of productivity. If the gains are predominantly driven by intense cost cutting, then they may be unsustainable once demand revives more persistently. In this case, we would expect hiring to pick up quickly as the economic expansion takes hold. However, if the level or trend in productivity has risen due to technological or other improvements, then higher average productivity gains will continue.  In this case, the implications for hiring are not clear. Higher levels of productivity will show through in both higher potential and actual output for the economy, and so need not necessarily come at the cost of lower labor input.

The relative importance of these factors also has consequences for our assessment of the degree to which resource slack exists in the economy. Since a higher level or trend of productivity implies a higher path for potential output, a given level of actual GDP would also be associated with a greater degree of economic slack. That is, the good news on productivity, if sustained, suggests that as of today we have a larger output gap to fill In contrast, some are skeptical that the economy really is operating far below sustainable levels. They argue that much of the drop in output during the recession was the result of a permanent reduction in the economy’s productive capacity, perhaps because certain financial market practices that had for a time enabled additional investments have now been discredited. According to this view, the strong productivity growth of recent quarters only goes a fraction of the way toward offsetting this decline in the level of potential output.

Of course, the unemployment rate gives us another way to infer the degree of slack in the economy. My earlier discussion of the sharp rise in unemployment duration and decline in labor force attachment may lead one to think that slack is even greater than what is implied by the unemployment rate itself.

[click here to enlarge figure]

However, it is possible that longer durations and lower labor force attachment could reflect broader structural changes in the economy, such as a mismatch between the skills of the unemployed and those demanded by employers. There may also be other impediments that currently prevent workers from shifting to the industries or locations where jobs are available. Under these scenarios, labor market slack might actually be lower than what one might infer from the unemployment rate alone.

I have just given you 2 minutes of classic two-handed economist speak. In the final analysis, however, the sheer magnitude of unemployment today is so large that there is little doubt in my mind that there is considerable slack in the economy. Incorporating alternative views about productivity and labor market behavior do not alter this general conclusion. The debate really boils down to whether the amount of slack in the economy is large or is extremely large.

Should the Fed have done more?

Given this large degree of slack, there is a legitimate question of whether monetary policy could, and more fundamentally should, have done more to combat the deterioration in labor markets. As we all know, a lot was done. As the crisis arose, we first used our traditional tools, substantially cutting the federal funds rate and lending to banks through our discount window. As we neared a zero funds rate, we turned to nontraditional tools to clear up the choke points, providing liquidity directly to nonbank financial institutions and supporting a number of short-term credit markets. Finally, we reduced long-term interest rates further by purchasing additional medium- and long-term Treasury bonds, mortgage-backed securities, and the debt of government-sponsored enterprises.

These nontraditional actions helped us avoid what easily could have been an even more severe economic contraction. But the unemployment rate still hit 10 percent this fall.

Had we done more, the most plausible action would have been to expand our Large Scale Asset Purchases (LSAP) program. Precisely quantifying the effect this would have had is difficult. A good place to start, though, is to look at the recent empirical evidence.[3] When significant new asset purchases were announced, our big, fluid financial markets built that information immediately into asset prices. For example, right after the March 2009 Treasury purchase announcement, ten-year Treasury yields fell about 50 basis points. Comparable declines occurred in Option Adjusted Spreads (OAS) on the announcement of agency mortgage-backed securities (MBS) purchases in November 2008. It might be reasonable to infer that say, doubling the size of the LSAPs might have doubled this impact on rates.

However, I would attach more than the usual amount of uncertainty to such an inference. Part of my hesitation reflects our lack of understanding about the interactions between nontraditional monetary policy, interest rates, and economic activity. While research efforts at the Federal Reserve and elsewhere to assess the effects of nonstandard monetary policy have been ramped up considerably, to date we do not have a robust suite of formal models to reliably calibrate interventions of this sort.

Moreover, there are reasons to expect that the impact of recent nontraditional policy actions might not have scaled up so simply. We initially responded to the financial crisis with our highest-value tool—a reduction in the funds rate—and then moved to our best alternative policies as interest rates approached zero. Finally, we turned to the LSAPs, which were designed to further lower long-term interest rates and thus stimulate demand for interest-sensitive spending, such as business fixed investment, housing, and durables goods expenditures. But the influence of lower rates on private sector decision-making may have reached the point of second-order importance relative to the countervailing forces of the housing overhang, business and household caution, and considerably tighter lending standards.

Moreover, although it is impossible to quantify, a portion of the impact of our nontraditional actions may have come simply from boosting confidence. In those very dark times, I believe households, businesses, and financial markets were reassured that policymakers were acting in a decisive manner. Further asset purchases would not have had an additional effect of this kind.

In addition, on a practical level, the portfolio of future purchases likely would have looked different and therefore their overall effectiveness might have deviated from our recent experience. The Fed’s typical monthly purchases of new issuance MBS were so large that it left very little floating supply for private investors. This could have forced a larger LSAP program to concentrate more heavily in Treasuries or existing MBS. Though the empirical evidence is limited, these assets likely are less close substitutes than new MBS for many of the instruments used to finance spending on new capital goods, housing, and consumer durables. Consequently, the effect of their purchase on economic activity may be less.

Finally, we must also keep in mind that more monetary stimulus also has costs. These could be considerable at higher LSAP levels. Many are already worried about the inflation implications of the Fed’s expanded balance sheet and the associated large increase in the monetary base. Currently, most of the increase in the monetary base is sitting idly in bank reserves—and because banks are not lending those reserves, they are not generating spending pressure. But leaving the current highly accommodative monetary policy in place for too long would eventually fuel inflationary pressures. Likewise, if the monetary base was expanded much beyond where we are today, the risk that such pressures would build as the economy recovers would be significantly increased. Furthermore, policymakers already face the task of unwinding a sizable balance sheet at the appropriate time and pace. Substantially increasing the size of asset purchases could have further complicated the exit process down the road.

That said, changes in economic conditions could alter the cost–benefit calculus with regard to the LSAP. Hopefully the recovery will progress without any serious bumps in the road and the inflation outlook will remain benign. But, as we have repeatedly indicated in the FOMC statements, the Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. ...

[Dual posted at MoneyWatch]

Bernanke: Current Economic and Financial Conditions and the Federal Budget

[A simulated interview based upon the speech Current economic and financial conditions and the federal budget, by Ben Bernanke, Chair, FRB (lightly edited - deletions only).]

Thanks for agreeing to this, I didn't think you would. Before turning to financial market conditions and the effects of the federal budget, the main topic today, let's start by getting your assessment and overview of the economy:

The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market--the number of new and continuing claims for unemployment insurance through late May--suggests that sizable job losses and further increases in unemployment are likely over the next few months.

What about the "green shoots" you talked about not too long ago? Are they withering or growing?

Recent data suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households' spending power will be boosted by the fiscal stimulus program.

So does that mean household consumption is likely to improve soon?

A number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions.

What about housing, how do you see things there?

Calculated Risk: No Rays of Sunshine Yet

Calculated Risk isn't quite as optimistic as Atlanta Fed President Dennis Lockhart:

Fed's Lockhart sees "catalysts for the start of modest recovery". by Calculated Risk: Excerpts from a speech by Altanta Fed President ... Lockhart today:

[T]he economic outlook is not indefinitely bad. Most forecasts, my own included, see catalysts for the start of modest recovery in the second half of the year.

I think almost everyone agrees with the "not indefinitely bad" comment. But I'm interested in what Lockhart sees as "catalysts for recovery":

With production falling—and expected to decline significantly more this quarter—I expect some reduction of excess business inventories, putting producers in a position to expand output as spending returns.

Right now it appears inventory levels are too high. ... So Lockhart might be correct, but it is too early to tell if producers will reduce inventory enough in the first half of 2009 to expand output in the second half of the year.

There are signs lower mortgage interest rates are helping housing markets on the margin. The January pending sales number was up, and there has been a spurt in refinancing activity. If historically low mortgage rates can be sustained over the coming months, I expect more buyers will be drawn into the market.

Actually the most recent pending home sales number was for December and the reason it showed an increase was because of more activity in areas with significant foreclosures.

Several factors should lift consumer spending as the year progresses. These factors include the dramatic fall in energy prices, greater stability in the housing market, and improving consumer confidence.

This is very possible, but I don't see evidence of this yet.

I should mention that last week the U.S. Census Bureau reported an unexpected increase in retail sales during January. I would like to see further confirmation of the underlying strength hinted at in this report, but on its face, the pickup in consumer spending is encouraging.

This is just one month of data and could be related to gift cards, so I wouldn't read much into that small increase.

Also contributing to the upturn seen in the consensus outlook are the large and targeted fiscal, credit, and monetary policies of the government and the Federal Reserve ... The intent of these aggressive and unprecedented policy actions is to support spending and fix the dysfunction in credit markets...

Indeed, we have seen modest, but hopeful, signs that financial markets are improving. ...

I think we can start looking for some rays of sunshine, but I don't see anything yet.

And once things do stop their downward slide, however long that takes, that doesn't mean that we can sound the all clear sign, step aside, and let the things take care of themselves (and suddenly move towards, say, balancing the budget). My reading of the aftermath of financial crises in the US and elsewhere in the world is that recovery is generally a slow, drawn out process. The depth of the downturn depends critically on the timing and effectiveness of the policy response, and that is its most important function of policy, but it can also help to shorten the recovery process once things turn around. Thus, once it finally does stop raining, it's still possible that without both monetary and fiscal policy actively engaged in the recovery process, the economy could experience a long period of overly sluggish growth as the economy crawls back to its long-run equilibrium. So let's be careful not to pull back on the policy levers before we are sufficiently certain that the economy can sustain itself on its own.

Access to Health Care

Ben Bernanke on Challenges for Health-Care Reform:

Access to health care is the first major challenge that health-care reform must address. In 2006, a total of 47 million Americans, or almost 16 percent of the population, lacked health insurance. ...[T]he evidence ... indicates that uninsured persons receive less health care than those who are insured and that their health suffers as a consequence. Per capita expenditures on health care for uninsured individuals are, on average, roughly half those for fully insured individuals. People who are uninsured are less likely to receive preventive and screening services, less likely to receive appropriate care to manage chronic illnesses, and more likely to die prematurely from cancer--largely because they tend to be diagnosed when the disease is more advanced. One recent study found that uninsured victims of automobile accidents receive 20 percent less treatment in hospitals and are 37 percent more likely to die of their injuries than those who are insured.

Update: More on health care from Dean Baker:

Insurance fraud, by Dean Baker: The health insurance system in the United States works great, as long as you stay healthy. It's only people who need medical care who have problems.

"Does Stabilizing Inflation Contribute to Stabilizing Economic Activity?"

I have been a proponent of inflation targeting procedures. However, many people take that to mean that inflation stability should take precedence over the stabilization of output and employment, or that we should suppress wages to prevent inflation. Here's a simulated interview with Frederic Mishkin generated from a recent speech that tries to clear this up (see also "Divine Coincidence is Unlikely" and "Mankiw on "Divine Coincidence" in Monetary Policy"). There are also comments about the use of core rather than headline inflation to guide monetary policy:

MT: Thanks for agreeing to do this in the simulation. Let's start by defining what the Fed is supposed to do. What are the Fed's goals?

FM: The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity.

MT: And how is that expressed practically?

FM: Research in monetary economics describes this purpose by specifying monetary policy objectives in terms of stabilizing both inflation and economic activity. Indeed, this specification of monetary policy objectives is exactly what is suggested by the dual mandate that the Congress has given to the Federal Reserve to promote both price stability and maximum employment.

MT: Let's get right to the big question. Does stabilizing inflation mean that the Fed is less focused on stable output and employment?

FM: We might worry that, under some circumstances, the objectives of stabilizing inflation and economic activity could conflict, particularly in the short run. However, economic research over the past three decades suggests that such conflicts may not, in fact, be that serious. Indeed, stabilizing inflation and stabilizing economic activity are mutually reinforcing not only in the long run, but in the short run as well.

MT: You mentioned both the short-run and the long-run. Let's start with the long-run becasue there is less controversy there. What do theory and evidence tell us about the long-run tradeoff between inflation and unemployment?

Milton, the Money Stock, and an Apolitical Fed

William Poole's birthday present to Milton Friedman is to give a speech saying his advice on monetary policy was less than optimal. Here's a summary of that part of Poole's speech from David Wessel followed by Poole's comments related to political influence on Fed policy:

Milton Friedman Wasn’t Right About Everything, by David Wessel, Real-Time Economics: William Poole, a self-described “card-carrying monetarist” who is now president of the St. Louis Federal Reserve Bank, says the Fed’s track record over the past 25 years is better than it would have been had it followed Milton Friedman’s prescription of maintaining steady growth in the money supply.

“I believe that the Fed’s actual adjustments of its federal funds rate target have yielded superior outcomes since 1982 to what we would have observed under steady money growth,” he said in the prepared text of a speech ... to mark the 95th anniversary of the late Milton Friedman’s birth. “I also believe that advances in knowledge permit us to say with some confidence that these gains are not just an accident of Alan Greenspan’s special skills and intuition,” Mr. Poole said.

So what’s the secret? Persuading the public, businesses and the markets that the Fed won’t let inflation get out of control or, in the jargon of economists, “anchoring inflationary expectations.”

“Everything Milton argued about money stock control is true,” he added, “but the effect of inflation expectations on the practice of monetary policy itself was, I believe, a missing element in the analysis. The economy functions differently when inflation expectations are firmly anchored. If a central bank allows expectations to become unanchored, then interest-rate control becomes a dangerous and potentially destabilizing policy. But should the practice of monetary policy depend on how well inflation expectations are anchored? I do not recall Milton discussing this question, perhaps because he believed that the best way to maintain well-anchored expectations over time was for the central bank to commit to steady and low money growth under all circumstances.”

Bernanke: Inflation Expectations and Inflation Forecasting

This won't be for everyone, but I know many of you have an interest in issues involving inflation, money growth, and Federal Reserve policy so I thought I'd post (slightly shortened) remarks made by Ben Bernanke on the relationship between monetary policy, inflation, inflation expectations, and on how the Fed forecasts inflation.

It's a good, general summary (along with references) of where the literature stands on these topics. In looking for new parts in the speech, two things caught my attention. First, Bernanke's commitment to gradualism as a policy guideline. Under gradualism, the federal funds rate is adjusted slowly to a new target rather than jumping to a new target immediately. That is, if the Fed wants to raise interest rates by one percent, it can do so gradually, e.g. in four .25 percent moves, or it can jump the full amount in one move. Gradualism argues for the smaller, incremental moves of the type we have seen recently.

Bernanke has emphasized gradualism before (e.g. see this speech from 2004, "Gradualism"), but given a second emphasis in his speech, the use of models where learning by both the monetary authorities and the public plays a role, gradualism is worth emphasizing again because the imposition of learning generally enhances the gradualist case. His 2004 speech gives indications of what he means by a gradualism, he will advocate moving slowly to a new target except in very unusual circumstances, and the new learning results he's emphasizing will reinforce this approach to policy:

Inflation Expectations and Inflation Forecasting, by Chairman Ben S. Bernanke, Chairman, FRB: ...As you know, the control of inflation is central to good monetary policy. ... Inflation injects noise into the price system, makes long-term financial planning more complex, and interacts in perverse ways with imperfectly indexed tax and accounting rules. In the short-to-medium term, the maintenance of price stability helps avoid the pattern of stop-go monetary policies that were the source of much instability in output and employment in the past. More fundamentally, experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally, with potentially adverse effects on risk-taking, investment, and other productive activities that are sensitive to the public's assessments of the prospects for future economic stability. In the long term, low inflation promotes growth, efficiency, and stability--which, all else being equal, support maximum sustainable employment...

Admittedly, measuring the long-term relationship between growth or productivity and inflation is difficult. For example, it may be that low inflation has accompanied good economic performance in part because countries that maintain low inflation tend to pursue other sound economic policies as well. Still, I think we can agree that, at a minimum, the opposite proposition--that inflationary policies promote employment growth in the long run--has been entirely discredited and, indeed, that policies based on this proposition have led to very bad outcomes whenever they have been applied.

Ben Bernanke: Embracing the Challenge of Free Trade: Competing and Prospering in a Global Economy

Ben Bernanke on the benefits and challenges of free trade. The speech covers:

• The Benefits of Trade
• Trade and Jobs
• What About Outsourcing Abroad?
• Responding to Job Displacement

Here's the speech itself. I expect this will convert all you doubters into enthusiastic supporters of the free trade agenda:

Embracing the Challenge of Free Trade: Competing and Prospering in a Global Economy, by Ben S. Bernanke, Chair, Federal Reserve Board: Trade is as old as humanity, or nearly so. Archaeological sites demonstrate that ancient peoples traded objects such as rare stones and shells across fairly long distances even in prehistoric times (Guisepi, 2000). Over the centuries, with stops and starts, the volume of trade has expanded exponentially, driven in large part by advances in transportation and communication technologies. Steamships replaced sailing ships; railroads succeeded canal barges; the telegraph supplanted the Pony Express. Today, in a world of container ships, jumbo jets, and the Internet, goods and many services are delivered faster and more cheaply (in inflation-adjusted terms) than ever before.¹

Janet Yellen: The U.S. Economy: Prospects and a Puzzle Revisited

Janet Yellen examines an important question, "Why is the labor market apparently going gangbusters, while growth in real GDP has turned in only a middling performance?":

The U.S. Economy: Prospects and a Puzzle Revisited, By Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco: ...Tonight I plan to discuss the prospects for the U.S. economy. I’d like to return to a theme that I discussed in a speech a few months ago and that has been on my mind ever since. It concerns a puzzling economic development. The puzzle, as I put it then, was: Why is the labor market apparently going gangbusters, while growth in real GDP has turned in only a middling performance? The reason I’d like to revisit the puzzle is that, in the intervening period, its mystery has deepened: economic growth has unexpectedly slowed from “middling” to a crawl, while the unemployment rate has actually inched down and employment growth has remained robust.

These and other recent developments have not dramatically changed my mainline forecast for the U.S. economy over the next year or so, but they have significantly increased the risks to the outlook, both for growth and inflation. While I’ve revised down my forecast for economic activity for the first half of 2007, I still expect to see a moderate pace in the second half of the year. At the same time, much of the news pertaining to the first quarter has been disappointing, and has raised the downside risk for growth. I continue to think that inflation is likely to edge down over the year, but, with labor markets appearing to have tightened further, rather than easing as I expected, the upside risks to this outlook have gotten bigger.

William Poole: Changing World Demographics and Trade Imbalances

William Poole has a perspective that differs from most on global imbalances and the low personal saving rate in the U.S. After briefly reviewing seven explanations for global imbalances and differences in cross-country saving rates, he concludes there's little to worry about since most of it can be explained by the life-cycle hypothesis combined with demographic differences between countries. In fact, he will argue that "to a large extent, the current situation is not fundamentally an imbalance but rather a condition that is conducive to coping with the major demographic changes that are occurring throughout the world." I agree demographics is part of the explanation, but I'm not convinced it is as important as he has concluded, particularly if it means we become complacent about the potential for a sudden rebalancing of global accounts:

Changing World Demographics and Trade Imbalances, by William Poole, President, Federal Reserve Bank of St. Louis: ...The world economy is characterized by three highly unusual conditions. First, the capital flow into the United States from the rest of the world and accompanying rest-of-world current account surplus—the U.S. current account deficit—is very large and persistent. Second, the U.S. personal saving rate has been falling and past year became negative for the first time since 1933. Third, high-income countries are just now beginning a demographic transition in which the fraction of retired persons in the total population will rise to levels never before experienced. The idea I will explore with you is that these three conditions are connected; the first two, I believe, are to a considerable extent a consequence of the third.

Today’s topic on the connection between demographic changes and trade balances certainly is important. My analysis combines demographic and economics facts with economic theory to provide some insights into the connections between demographic changes and international trade. ... I especially want to highlight my unease with using the term “imbalances” to characterize the current situation. That term almost begs for a policy response—how can policymakers allow imbalances to persist? Unfortunately, policy responses could well involve damaging protectionist measures. I will argue that, to a large extent, the current situation is not fundamentally an imbalance but rather a condition that is conducive to coping with the major demographic changes that are occurring throughout the world...

Current Account Balances: Facts and Explanations Large and persistent current account surpluses and deficits are common in the global economy today, as illustrated in Figure 1 [note: in text links are to originals]. Since early 1998, the U.S. current account has trended downward, a fact that has attracted much attention not only in the United States but also throughout the world. As a share of U.S. GDP, the U.S. current account deficit has increased from roughly 2 percent to a level exceeding 6.5 percent in 2006. ... It is clear that today’s U.S. current account deficit substantially exceeds any other such deficits during the second half of the last century.

The United States, however, is not the only country with a current account deficit that is a relatively large share of its gross domestic product. In fact, certain European nations fit such a description. Figure 2 ... shows this ratio for the European Union and for selected European countries, some of which have current account deficits relative to GDP larger than the United States. For example, both Spain and Portugal have current account deficits that are close to 10 percent of GDP.

"Bad Fiscal Policy Creates Pressure for Bad Monetary Policy"

Here's part of a speech on fiscal policy by Richard Fisher, president of the Federal Reserve Bank of Dallas:

Fiscal Issues: From Here to Eternity, President, by Richard W. Fisher, FRB Dallas: ...I am going to speak today ... about fiscal policy, an area into which central bankers rarely wander. ... Before doing so, let me remind you that the Federal Reserve is a strictly nonpartisan institution; when you enter the temple of the Federal Reserve, you check your partisan affiliation at the door...

According to official government trustee reports, the infinite-horizon discounted present value of our unfunded liability from Social Security and Medicare—in common language, the gap between what we will take in and what we have promised to pay—now stands at $83.9 trillion. The potent combination of lower birthrates, higher medical costs and longer life expectancies provides little reason to hope that the figure will fall.

Charles Plosser: Credibility and Commitment

Which produces a better outcome for the economy, a central bank with the discretion to respond as needed to any situation that might arise, or a central bank credibly committed to a rule that it will follow even when unusual events occur? Philadelphia Fed President Charles Plosser has a very nice non-technical discussion of this issue [see also "Explicit Inflation Targeting as a Commitment Device," something similar I wrote about a month ago, which includes responses from Jamie Galbraith and Dean Baker to the idea of committing to inflation targets, disagreements with the story I told and the story told below about why inflation fell in the 1980s, and related issues]:

Credibility and Commitment, by Charles I. Plosser, President Federal Reserve Bank of Philadelphia: ...I’d like to begin by asking a question. How many of you have ever decided that you would be healthier and happier if you lost a few pounds and so made a New Year’s resolution to go on a diet? I know I have. But, if you are like me, tomorrow comes and it’s your wife’s or husband’s birthday... Then over the weekend there is a party in the neighborhood and the food is outstanding, so you decide that the diet can wait until next week. But as the days and weeks go by, next week just never comes, and you, in effect, abandon your dieting plan altogether. We all know we would have been better off if we had just stuck to our diet. Yet somehow we failed to follow through consistently on what was basically a good plan.

At this point some of you may be thinking, "What does this have to do with monetary policy?" But the fact is that policymakers often have a good plan, as well, but may not be able to resist eating that soufflé. Consequently, not only would the good plan go out the window, but the public would lose confidence in the policymaker’s credibility to follow through on its promises. ...

Today, I am going to address one critical element of the Fed’s ability to achieve its objectives—the importance of making credible commitments.

Bernanke's Testimony before the Joint Economic Committee of Congress

Federal Reserve Chairman Ben Bernanke testified today before the Joint Economic Committee of Congress. In his remarks, he clarified the Fed's position and indicated that there should be no expectation of a rate cut any time soon:

Bernanke plays down need for rate cuts, by Krishna Guha, Financial Times: The Federal Reserve sees no need to cut interest rates in the light of adverse recent economic data, Ben Bernanke said on Wednesday. The Fed chairman said ”to date, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing in core inflation”.

The Federal Reserve chairman also emphasised that the US central bank remains concerned about the threat that inflation will not moderate as expected, arguing that high levels of resource utilisation could still fuel price rises. He added the US central bank was not as confident in its outlook as it had been a couple of months ago, when it was increasingly upbeat about the prospects for a soft landing.

Mr Bernanke’s remarks ... offered no hint that the Fed yet believes that it will have to cut interest rates soon, as the market expects. But he recognised that “uncertainties around the outlook have increased” and said the Fed would respond in the light of incoming economic data.

His comments came as the Department of Commerce released figures showing durable goods orders bounced back only weakly in February after a sharp plunge in January. ... Mr Bernanke told the Joint Economic Committee of Congress “the possibility that the recent weakness in business spending will persist is an additional downside risk.”

The Federal Reserve chairman hinted the weakness in business spending had come as a surprise to the Fed ... However, Mr Bernanke added “despite the recent weak readings, we expect business investment in equipment and software to grow at a moderate pace this year”...

Moreover, the Fed chairman signalled that he was less alarmed than many investors by the distress in the subprime mortgage market. “At this juncture…the impact on the broader economy and financial markets of the problems in the subprime market seem likely to be contained,” he said ... adding “we will continue to monitor this situation closely.”

He reiterated the Fed’s view that the drag from cut-backs in residential investment should “wane” as builders work off the inventory of unsold new homes – though he recognised that the housing market correction “could turn out to be more severe than we currently expect...”

Overall, Mr Bernanke indicated that the US central bank remains relatively upbeat on the prospects for US growth. ... Mr Bernanke reiterated a series of reasons why the Fed remains concerned about inflation. “The high level of resource utilisation remains an important upside risk to continued progress on reducing inflation,” he said. The Fed chairman refered to the “tightness in the labour market” and to difficulties firms face hiring qualified workers.

Allan Meltzer, in a comment about Larry Summers' recent column calling on the Fed to ease policy in response to any signs of weakness in the economy, explains why the Fed is reluctant to ease too quickly:

Allan Meltzer: We all have heard many times that those who forget their history are likely to repeat it. One of the main reasons that the Great Inflation continued from 1965 to 1979 was that the Federal Reserve (and the Bank of England) put great weight on unemployment and too little weight on inflation. In the 1970s the Federal Reserve waited for unemployment to get above 7 per cent before it abandoned any effort to lower inflation.

The US saw both inflation and the unemployment rate rise to postwar peaks. Paul Volcker ended this policy by letting unemployment rise as required to bring down inflation. The public supported him.

Larry Summers wants to repeat the earlier mistakes. Even before the unemployment has started to rise, he wants the Fed to anticipate the rise and react against it by lowering interest rates.

An economy that cannot accept some temporary increase in the unemployment rate will live with increasing inflation followed by low investment, declining real wages, and higher unemployment. Fortunately, most of the members of the Open Market Committee understand that. And the public as in 1979-80 will demand an end to the policy.

See also Kash Mansori, The Big Picture, Bloomberg, WSJ, NYT, and the Washington Post.

Here is the text of Bernanke's prepared remarks:

Testimony of Chairman Ben S. Bernanke, by Ben Bernanke, Federal Reserve Chair: Chairman Schumer, Vice Chairman Maloney, Representative Saxton, and other members of the Committee, thank you for inviting me here this morning to present an update on the outlook for the U.S. economy. I will begin with a discussion of real economic activity and then turn to inflation.

Frederic Mishkin: Inflation Dynamics

If you are interested in inflation dynamics and recent research suggesting that inflation dynamics have changed, this speech by Federal Reserve governor Frederic Mishkin looks at three important questions:

1. What is the available evidence on changes in inflation persistence in recent years?
2. What is the available evidence on changes in the slope of the Phillips curve?
3. What role do other variables play in the inflation process?

The speech summarizes and interprets research on these questions, and discusses the impact of the research on the conduct of monetary policy. As I've explained before, I am in agreement with his conclusions about the role of policy in anchoring expectations and how this has changed estimated inflation dynamics, and what this implies for monetary policy and inflation targeting. Too bad my monetary theory and policy class ended last week - I can't make them read this [Update: Brad DeLong provides a nice summary of the sections discussing the role of policy in anchoring expectations]:

Inflation Dynamics, by Frederic S. Mishkin, Federal Reserve Governor: Under its dual mandate, the Federal Reserve seeks to promote both price stability and maximum sustainable employment.[1] For this reason, we at the Federal Reserve are acutely interested in the inflation process, both to better understand the past and--given the inherent lags with which monetary policy affects the economy--to try to forecast the future. We economists have made some important strides in our understanding of inflation dynamics in recent years. To be sure, substantial gaps in our knowledge remain, and forecasting is still a famously imprecise task, but our increased understanding offers the hope that central banks will be able to continue and perhaps even improve upon their successful performance of recent years.

Today, I will outline what I see as the key stylized facts that research has in recent years uncovered about changes in the dynamics of inflation and will present my view of how to interpret these findings. The interpretation has important implications for how we should think about the conduct of monetary policy and what we think might happen to inflation over the next couple of years. I will address these two issues in the final part of the talk.

Geithner: Credit Markets Innovations and Their Implications

New York Fed president Tim Geithner, who hasn't been shy about warning about financial risks from financial market innovation, doesn't seem too concerned that problems in the subprime mortgage market will spread and cause wider disruptions. Here's part of a longer speech:

Credit Markets Innovations and Their Implications, by Timothy Geithner, NY Fed President: ...The latest wave of credit market innovations has elicited some concerns about their implications for the stability of the financial system, concerns similar to those associated with earlier periods of rapid change in financial markets. Will the most recent credit market innovations amplify credit cycles, contributing to "excessive" lending in times of relative stability, and then magnify the contraction in credit that follows? Will they introduce greater volatility in financial markets? Will they create greater risk of systemic financial crisis?

These concerns have been heightened in some quarters by the problems currently being experienced in the subprime mortgage sector. It will take some time before the full implications are understood and the full impact can be assessed. As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole.

Indeed, economic theory and recent practical experience offer some reassurance against both these specific concerns and more general worries about the implications of credit market innovations for the performance of the financial system. ...

There are ... compelling arguments in favor of a generally positive assessment of the consequences of innovation. Does experience provide support for these arguments, or are these changes too new for us to know? ...

We are now well into the third decade of experience with the consequences of these earlier innovations, and this history offers some useful lessons for evaluating the probable impact of the latest changes in credit markets.

The ease with which the U.S. financial system absorbed the substantial scale of corporate defaults that peaked in recent years in 2002 provides some support for the argument that broader and deeper capital markets make the system more resilient. In general, there does not seem to be strong empirical support for the proposition that derivatives increase volatility in financial markets. ...

Credit market innovation does not appear to have resulted in a large increase in leverage in the corporate sector, as some had feared. ...

Default rates do not appear to have risen, nor recovery rates fallen as these credit innovations have spread, despite concerns they might lead to excess lending, the mis-pricing of credit risk and more messy and more complicated workouts, resulting from the greater diffusion of the investor base.

And although the sources of the broad moderation in GDP volatility observed in the United States over the past two decades are still the subject of debate, the fact that this moderation occurred during a period of extensive innovation in credit and other financial markets should provide some comfort for those who expected the opposite.

Innovations in credit markets are inevitably accompanied by challenges. Indeed, the history of innovation in financial markets provides many examples of periods of rapid change accompanied by fraud and abuse, by challenges in assessing value and risk, by concerns about the adequacy of investor and consumer protection, and by unexpected behavior of prices, defaults and correlations. To some degree, these types of problems are the inevitable consequence of change and innovation.

Although recent experience as well as theory provide some reassurance..., these judgments require qualification. Some aspects of this latest wave of innovation are different in substance ... from their predecessors. ... [B]road changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.

What should policymakers to do mitigate these risks?

We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure. ...

The Federal Reserve is actively involved in a range of efforts... The stronger these shock absorbers, the more resilient markets will be in the face of future shocks, and the more confident we can be that banks will be a source of strength and of liquidity to markets in periods of stress and that the financial system will contribute to improved economic performance over time.

Here's more from the Fed from the last few days:

• What Can We Expect from the Yield Curve?, by Charles I. Plosser, President Federal Reserve Bank of Philadelphia
• Vice Chairman Kohn on asset-pricing puzzles, credit risk, and credit derivatives
• Governor Kroszner on recent innovations in credit markets
• The Fed's View of the Sub-Prime Mortgage Market

Update: See also "Toothless Fed, Part 2 (Risk Management Shortcomings)" from Yves Smith at naked capitalism.

Janet Yellen: The Asian Financial Crisis Ten Years Later

Janet Yell, president of the San Francisco Fed, with an interesting discussion of the Asian financial crisis:

The Asian Financial Crisis Ten Years Later: Assessing the Past and Looking to the Future, by Janet Yellen, President, FRBSF: Good afternoon. ... This is the first in a series of presentations, seminars, and conferences the San Francisco Fed will be involved with over this year as we explore various facets of the Asian financial crisis, focusing on the stability and resiliency of financial sectors...

At the time of the crisis, I was the Chair of President Clinton’s Council of Economic Advisers, and, as you may imagine, it was definitely a “front-burner” issue for us. As the crisis spread from country to country, there was deep concern about how big the impact would be on the U.S. economy... For the five Asian nations most associated with the crisis—Thailand, Korea, Indonesia, the Philippines, and Malaysia—the toll in both human and economic terms was enormous: in 1998, these countries saw their economies shrink by an average of 7.7 percent and many millions of their people lost their jobs. More broadly, there was concern that the crisis had revealed new sources of risk in the international financial architecture. ...

In my remarks this afternoon, ... I will first review the major strands of thought in the literature on the causes of the crisis, highlighting some of the vulnerabilities that were contributing factors. Then I will turn to conditions in the affected countries today and examine how their policy responses to the crisis have shaped the current Asian financial environment. I will round out my remarks with some thoughts on lessons learned, particularly for international financial institutions, and observations on China in the current environment. ...

Ben Bernanke Warns on Inequality

Today, Ben Bernanke joins another Federal Reserve official, Janet Yellen, in warning about the dangers of widening inequality. Here's the summary by David Wessel of the Wall Street Journal:

Bernanke Cautions About Inequality, But Warns of Too Many Limitations, by David Wessel, WSJ: Federal Reserve Chairman Ben Bernanke cautioned that widening inequality may make Americans "less willing to accept the dynamism… so essential to economic progress," but warned politicians to avoid responding by limiting the flexibility of labor markets or erecting barriers to international trade in investment.

Wiser responses, he said, would be to improve education and training and cushion the dislocations caused by technology and globalization, such as making health and pension benefits more portable and offering retraining and job-search assistance to displaced workers. ...

"Although average economic well-being has increased considerably over time," he said "the degree of inequality in economic outcomes has increased as well… for at least three decades"...

With 48 academic references, [the speech] documented the inequality trend and detailed reasons behind it -- from the extra wages that employers are willing to pay workers with formal education to the decline of unions to the impact of globalization, which he said has been "moderate and almost surely less important than the effects of… technological change."

The Fed chairman said "firm conclusions about the extent to which policy should attempt to offset inequality… is… properly left to the political process." But he offered three principles that he said are "broadly accepted in our society" -- economic opportunity should be as widely distributed and equal as possible, economic outcomes needn't be equal but should be linked to a person's contributions and people should get some insurance against "the most adverse economic outcome."

"We… believe," he said, "that no one should be allowed to slip too far down the economic ladder, especially for reasons beyond his or her control." ... [Note - transcription errors in quotes fixed.]

I agree. Here's the entire speech:

The Level and Distribution of Economic Well-Being, Chairman Ben S. Bernanke, Federal Reserve Board of Governors: A bedrock American principle is the idea that all individuals should have the opportunity to succeed on the basis of their own effort, skill, and ingenuity. Equality of economic opportunity appeals to our sense of fairness, certainly, but it also strengthens our economy. If each person is free to develop and apply his or her talents to the greatest extent possible, then both the individual and the economy benefit.

Bernanke: Entitlement Spending Threatens Future Economy

Federal Reserve Chair Ben Bernanke testified before the Senate Budget Committee today. Greg Ip summarizes his testimony [Update: Video of testimony from CSPAN]:

Bernanke to Congress: Time for Action, by Greg Ip, Washington Wire: Bernanke Federal Reserve Chairman Ben Bernanke testified today that “long-term fiscal imbalances” due to rising spending on entitlement programs such as Medicare and Social Security imperil the economy. “If early and meaningful action is not taken,” he warned Congress, “the U.S. economy could be seriously weakened, with future generations bearing much of the cost.”

When Senate Budget Committee Chairman Kent Conrad (D., N.D.) asked, “How urgent is it that we address these long term imbalances?” Bernanke replied: “The right time to start is about 10 years ago.”

I think that Bernanke should speak out on the budget issue if he is concerned, and I was pleased that he adopted a neutral stance and resisted saying whether taxes or spending changes are to be preferred in dealing with the projected budget problem. I don't think the Fed should take a position one way or the other, though hearing the Fed's view on the consequences of each strategy for dealing with the deficit issue would be helpful.

But if this had been a draft of his testimony rather than a finished product, I would have made three suggestions:

1. The Fed's job is monetary policy, not fiscal policy. Make the connection between budget deficits and, through the government budget constraint, the choices the Fed would have to make as a consequence. For example, if the economy were to slump as forecast in one scenario given in the talk, would the Fed steadfastly refuse to monetize the debt? Will the Fed's hand be forced in any particular way, or will it face any difficult tradeoffs due to the budget problem? I think the Fed would have difficult choices to make if the deficit increased as projected and it would be helpful to hear the the Bernanke's view on how the Fed would react. [Update: see Jim Hamilton on this point.]

2. The Social Security and Medicare problems are not of the same order of magnitude. Draw a sharper distinction and make it clear that Medicare is far and away the biggest worry.

3. The speech reads as if there are only two choices with respect to the budget problem, changing taxes or changing spending. But there is another choice too and it is related to the fact that Medicare is the biggest worry. By reorganizing our health care delivery system - e.g. a universal care, single-payer system - it may be possible to realize substantial savings. While it could be argued that this comes under the heading of changes in expenditures, achieving budget reduction by reorganizing the health care system is fundamentally different from what we usually think of as spending cuts.

Here's the written part of Bernanke's testimony before the Senate:

Long-term fiscal challenges facing the United States, by Ben Bernanke, Federal Reserve Chairman: Chairman Conrad, Senator Gregg, and other members of the Committee, I am pleased to be here to offer my views on the federal budget and related issues. At the outset, I should underscore that I speak only for myself and not necessarily for my colleagues at the Federal Reserve.