The Fed has lots of credibility; will they use it wisely?

Here’s Janet Yellen:

The Federal Reserve may need to run a “high-pressure economy” to reverse damage from the 2008-2009 crisis that depressed output, sidelined workers, and risks becoming a permanent scar, Fed Chair Janet Yellen said on Friday in a broad review of where the recovery may still fall short.

Though not addressing interest rates or immediate policy concerns directly, Yellen laid out the deepening concern at the Fed that U.S. economic potential is slipping and aggressive steps may be needed to rebuild it.

I see this as a big mistake. The Fed needs to focus on smoothing out the path of nominal spending.  There’s not much they can do about the economy’s “potential”, and trying to boost it would end up destabilizing the economy.  Back in the 1960s, the Fed also believed there was a permanent trade-off between inflation and unemployment—it did not end well.

Yellen’s comments, while posed as questions that need more research, still add an important voice to an intensifying debate within the Fed over whether economic growth is close enough to normal to need steady interest rate increases, or whether it remains subpar and scarred, a theory pressed by Harvard economist and former U.S. Treasury Secretary, Lawrence Summers, among others.

Her remarks jarred the U.S. bond market on Friday afternoon, where they were interpreted as perhaps a willingness to allow inflation to run beyond the Fed’s 2.0 percent target. Prices on longer dated U.S. Treasuries, which are most sensitive to inflation expectations, fell sharply and their yields shot higher.

Yellen’s statement was not an indication of Fed policy, but merely the musings of one person.  It’s very unlikely to be put into action.  And yet bond prices plunged. Now imagine if all 12 members of the FOMC got on a stage and said they were raising the inflation target from 2% to 3%.  The impact on the bond market would have been at least 10 times greater than what occurred yesterday.  There’s no question that the Fed can move inflation expectations, the question is what should they be doing?  Credibility has never been the Fed’s problem.  In late 2008, the Fed’s contractionary policy was highly credible—markets saw where the Fed was pushing NGDP.  In 2009-10 their explicit decision not to return NGDP to the old trend line was highly credible.

Jeffrey Gundlach, chief executive of DoubleLine Capital, said he read Yellen as saying, “‘You don’t have to tighten policy just because inflation goes to over 2 percent.’

“Inflation can go to 3 percent, if the Fed thinks this is temporary,” said Gundlach, who agreed Yellen was striking a chord similar to Summer’s “secular stagnation” thesis. “Yellen is thinking independently and willing to act on what she thinks.”

It would be destabilizing to let inflation go to 3% while unemployment is low.  It would bring the recovery to a premature end, triggering another recession as soon as the economy was hit by another oil shock.  Instead, the Fed should shoot for 3% inflation during the next recession—not during this expansion.  But they currently lack a policy regime capable of achieving that (countercyclical) outcome.  Yellen’s policy remains resolutely procyclical.  NGDPLT anyone?

“If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand,” Yellen said. It would “make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn.”

That’s a really big “if”, which goes against 50 years of macroeconomic research.  That doesn’t mean it’s wrong, we learn new things all the time.  But this theory is not even close to being ready to implement.  At a minimum, we’d need many years of research and testing of the idea, before using the US economy as a test tube for Yellen’s latest theory.

PS.  Commenters invariably tell me that easier money leads to more investment, and hence more growth.  Do you really believe that macroeconomists haven’t been aware of that?  The problem is that it doesn’t boost the economy’s long-term growth rate, and hence creates more cyclical instability.  It might be helpful to consider “investment” as “home building”—one of its biggest components.  It’s true that even today the flow of housing services from homes is larger than it might have been without all those homes built during the 2003-06 boom.  Does the mean the 2003-06 housing boom boosted the long term growth rate of the US?  Did it help to stabilize the US economy?

PPS.  Don’t take this post as a criticism of Yellen’s current policy stance within the Fed.  I don’t have a problem with her recent votes (not to raise rates.)

PPPS.  I have a related post at Econlog, which discusses the issue of credibility and inflation expectations.

HT:  TravisV


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33 Responses to “The Fed has lots of credibility; will they use it wisely?”

  1. Gravatar of bill bill
    15. October 2016 at 11:21

    I reacted somewhat differently to Yellen’s comments. I took it to mean that she was leaning toward holding off on any further tightening until inflation had actually exceeded 2% instead of trying to react in advance with hopes of asymptotically approaching 2% based on estimates of NAIRU. That she was considering that NAIRU may not apply yet because participation could increase further. That said, I wish they’d just speak more clearly.

  2. Gravatar of ssumner ssumner
    15. October 2016 at 11:26

    Bill, I think you need to distinguish between what she might be trying to do, and what her ideas would effectively accomplish. In my view, they’d make policy even more procyclical.

    People need to realize that the problem is not easy money, or tight money, it’s procyclical money.

  3. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    15. October 2016 at 11:31

    Alive and well, and living in Venezuela; the Laws of Supply and Demand;

    http://www.wsj.com/articles/venezuela-backs-away-from-price-controls-as-citizens-go-hungry-1476475368

    ————-quote————
    President Nicolás Maduro’s government has begun dismantling price controls, a major policy shift that aims to ease widespread unrest by letting shops sell food at market prices but is worsening Venezuela’s already punishing inflation.

    What began as a limited experiment in March in western Zulia state, which borders Colombia, has since been rolled out to six other border states, according to ruling-party governors and interviews with supermarket owners and shoppers across the country. One of the governors says plans are afoot to extend the program to the capital, Caracas, where food riots recently broke out just outside the presidential palace.

    “Before there was nothing; now there’s everything,” said Jesús Barrios, 36, as he shopped in Maracaibo, the state capital of Zulia.
    —————endquote————-

    Bernie Sanders could not be reached for comment.

  4. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    15. October 2016 at 11:41

    More from the WSJ article;

    ————quote———-
    This week in the private De Candido supermarket in Maracaibo, 2 pounds of rice that sells for 12 cents under price controls elsewhere was selling for $2; a 2-pound bag of sugar pegged at 40 cents went for $3.50.

    Six months ago, hundreds of shoppers broke through the supermarket’s windows and doors to get to the scarce price-controlled products after a delivery. But on Thursday, a few dozen shoppers calmly browsed shelves filled with Colombian products as 12 cashiers idly stood by.

    “At least I can come in and buy, even if at high cost,” said Ana Atencio, a nurse who came in after her shift to get some sugar for her baby’s milk. “Before, I wouldn’t even dream of it because of the line and people fighting.”

    Still, buying that bag of sugar alone would swallow almost a quarter of her monthly wage.

    On the other end of the country, Gisela Lares used to camp outside the shops in Puerto Ordaz to buy food, sometimes even breastfeeding her baby in line. Then came Brazilian imports.

    “I used to look for anything, whatever was going, even if it meant getting in line the day before,” she said. “I haven’t had to line up for two months now.”
    ————endquote————

    But inflation is up!

  5. Gravatar of bill bill
    15. October 2016 at 11:42

    Scott,
    Very true.

  6. Gravatar of Kevin Erdmann Kevin Erdmann
    15. October 2016 at 13:56

    Where did we over invest in housing Scott? Boston? New York? California? Do you have too many housing units in Boston, and it’s cramping your productivity growth? Is that the big problem up there? The problem is the opposite and always was, even in 2006.
    Since everyone is aggressively wrong about this, we have imposed the problem nationally with a hamstrung mortgage market since 2006. A higher inflation target would be helpful because, lacking a middle class mortgage market, equity inflation is an important source of housing funding. This will trigger real residential investment, lowering rent inflation.
    The jobs that would replace lost manufacturing jobs are in nontradable sectors (iincluding construction). Those jobs, by definition, are located near the customer base. It is pragmatically illegal for those workers to live where those jobs are. Lack of housing is behind the productivity bust.

  7. Gravatar of Ray Lopez Ray Lopez
    15. October 2016 at 13:56

    Finally! Back to our regularly scheduled kookiness: monetarism (aka fooled by randomness). Credibility? Yeah, aka the Placebo Effect in economics. Works in medicine, so why not economics? In fact, some claim (and I tend to agree), having lived through the Great Depression (unlike Sumner, who only has lived it through books) that FDR’s “fireside chats” in 1933/1934 helped turn around the bank crisis, and it was NOT going off the Gold Standard that turned the economy around. Seems to make sense, since Argentina went off the Gold Standard in 1929 and it did not help their economy from spiraling down.

    Credibility, something Sumner lacks.

  8. Gravatar of Rajat Rajat
    15. October 2016 at 14:13

    “the Fed should shoot for 3% inflation during the next recession—not during this expansion. But they currently lack a policy regime capable of achieving that (countercyclical) outcome.”

    Scott, here’s one thing lots of people (including me to some extent) have problems understanding: how inflation can be high duration a recession. Of course, those who recall stagflation know how it can be – due to supply shocks. And NGDPLT makes obvious sense in this context. But if you’re saying that recessions are usually monetary phenomena and the Fed should “shoot for 3% inflation during the next recession”, it sounds like you’re putting forward a procyclical policy: when you’re in a demand-driven slump, aim to overshoot. I think the problem is that most people have trouble fathoming how prices can rise rapidly when there is lots of demand-driven ‘slack’ in the economic (ie high UnN). I think you’ve mentioned examples many times before from the Great Depression when the WPI rose rapidly after the US devalued, even though UnN was high. Readers would benefit if you refer to examples like that more often.

    Also, on Yellen, I suspect she is thinking of how the fall in the prime age participation rate – and hence employment – could recover to a greater extent if the economy ran hotter.

  9. Gravatar of Matthew Waters Matthew Waters
    15. October 2016 at 18:57

    “Where did we over invest in housing Scott?”

    I think you’re misunderstanding bad investment. It is possible to badly invest in San Francisco, NYC, etc. because at some price you do lose money. To put it more specifically, it is possible for a high-end condo developer to not get an return on invested capital higher than the risk-free rate plus a risk premium.

    For SF, NYC and Boston, the building codes need to be dramatically relaxed. Not just for zoning to approve the building, but for all of the highly unnecessary and idiosyncratic codes once the building is approved. All of that creates housing that’s too expensive, but you can still have investment losses in such an underbuilt area.

  10. Gravatar of Matthew Waters Matthew Waters
    15. October 2016 at 19:02

    Also, Scott’s post is a bit of a confusing statement in response to a confusing statement from Yellen. “Procyclical” anything in monetary policy just seems to muddy the waters.

    There should be either an inflation or NGDP level target. I suppose level targeting is “procyclical” because level targeting is an internal negative feedback loop. But why then have a 3% inflation target in recessions and not out of recessions? Why not just have “3% inflation level target.” Whenever these recessions happen, you end up with the same price level.

    I even saw this: “And yet bond prices plunged.” I see a reasoning from an interest rate level here. In general, this is an oddly un-Sumnerian post.

  11. Gravatar of Kevin Erdmann Kevin Erdmann
    15. October 2016 at 19:04

    Matthew, in the case of urban real estate, where the returns are mostly from economic rents from limited access, social returns and individual returns can be negatively related.

  12. Gravatar of Fred Fred
    15. October 2016 at 19:22

    I disagree with this, actually. Most importantly, I don’t think the Fed is nearly as credible as it ought to be, which is why financial markets, as you’ve pointed out many times, don’t buy that they’ll hit their (far too low) inflation target over the long run, notwithstanding their overly rosy forecasts; that’s even without pricing in the same amount of tightening as SEP forecasts. The market reaction to this speech in this sense is actually the exact opposite of what the Fed would want to see: it undercuts the narrative of anchored expectations that forms the basis for further tightening.

    On the subject of running hot, I’m less inclined toward this argument than I was, say, a year or two ago, but I don’t think it could hurt much. The argument, I think, is that hysteresis (I know you’ve said in the past you don’t quite buy into this) is a dynamic process and, to the extent that discouraged/marginally attached workers could possibly reenter the labor force, even with the slimmest of chances, the Fed ought to pave the way for it. Tightening, surely, would prevent that from happening. If they run hot and are wrong, they get slightly higher inflation; if they don’t run hot and are wrong, they’ve willed lower productivity into existence. Not to mention, a “symmetric” target should allow some overshooting to compensate for undershooting.

    But I do agree with you (and also with Eric Rosengren who very recently made similar arguments) that this is probably a stretch. Most of the literature finds that reentry rates taper off fairly early into recoveries. The counter might be along with the lines of a Rogoff-Reinhart effect since there’s hardly an apples-to-apples comparison here. I also don’t buy that there’s upward momentum in labor participation as Yellen seems to think at the moment: we saw the same band–62.7 to 62.9 or so–earlier in the year, if memory serves, and it evaporated not long after. The risk calculus is what sways me, and I do think there’s an argument for an overshoot, if only higher nominal interest rates for more ammunition once the next recession hits.

  13. Gravatar of Fred Fred
    15. October 2016 at 19:28

    I just realized I probably misunderstood your argument on credibility. I think you may have been arguing this more along the lines of “monetary policy can never run out of ammunition, and therefore the Fed can never loose its ability to impact nominal growth (see Zimbabwe).” If this is the case, I completely agree with you. If you were arguing something along the lines as Narayana Kocherlakota–which is essentially that the economy has behaved in a large sense as the Fed forecasted because it willed these outcomes into existence–then I disagree, but I don’t think you were making this point.

  14. Gravatar of ssumner ssumner
    15. October 2016 at 20:37

    Kevin, There are many problems with the housing market, including the tax deductibility of mortgage interest. But you don’t solve those problems with procyclical monetary policy—that just makes the business cycle worse.

    BTW, I did not say we over-invested in housing, but certainly our housing policy has been destabilizing, as you have shown.

    Ray, And so Mr. Money is Neutral believes in the miracle of fireside chats, which of course only work if money is not neutral. You remind me of Trump, an uncanny ability to get EVERYTHING wrong.

    Rajat, NGDP targeting is exactly the sort of countercyclical policy I have in mind–high inflation during recessions.

    Matthew, I don’t think you know what “reasoning from a price change” means. It means starting your reasoning with a price change, not the shock that caused it. Here I started with the shock that caused it.

    Fred, People need to stop thinking in terms of hawks and doves, or easy money and tight money. The only important issue is procyclical or countercyclical.

  15. Gravatar of Bill Ellis Bill Ellis
    15. October 2016 at 21:15

    Just trying get this part strait in my head…

    so 3% inflation kills a recovery . But not until some economic shock…?

    because we would be able to handle the shock at 2% inflation but the shock would tip us into a recession 3%

    ????

    how about 2.5% inflation.. ??

    Seems to me If a spike in oil prices was big enough to slow the economy to the point of recession… that 1 point difference in inflation rates would not be the deciding factor…

  16. Gravatar of Kevin Erdmann Kevin Erdmann
    15. October 2016 at 21:39

    Scott, those are also problems. But tax policy isn’t related to cyclical policy. Housing is the defining sector of this time, the way oil may have defined the 1970s. Growth in housing now would be countercyclical, even if it was related to a temporary 3% inflation target.

  17. Gravatar of Saturos Saturos
    15. October 2016 at 22:42

    Alarming: http://www.telegraph.co.uk/news/2016/10/14/mark-carney-says-he-will-not-take-instruction-after-theresa-may/

  18. Gravatar of Ray Lopez Ray Lopez
    15. October 2016 at 23:15

    @ssumner – “Ray, And so Mr. Money is Neutral believes in the miracle of fireside chats, which of course only work if money is not neutral.”- not true, recall animal spirits and people spending more (that’s not monetarism).

  19. Gravatar of Ray Lopez Ray Lopez
    15. October 2016 at 23:34

    @ssumner – I notice your difficulty in economics is confusing cause and effect (money expansion and contraction follows the gyration of the market, it does not cause them). You seem to think that if everybody starts spending, due to animal spirits, and banks expand credit in response to their customers increased demand, that this is monetarism? You remind me of Solow’s comment about Friedman, monetarism, and sex (I trust you’re well read enough to know the passage). Everything to you is monetarism. If a meteor wipes out life on earth and velocity of money goes to zero, that’s evidence that the central bank is at fault.

    Bonus trivia: I just recently learned that David Hume, who came up with the quantity theory of money, also has a passage where he anticipates money non-neutrality and SRAS curves sloping up. From A Concise History of Economic Thought – Groenewegen (2003) – (on Hume): “When there is an inflow of money, wages and prices do not rise immediately, since there is a intermediate phase during which economic activity, the industry of people and employment may increase, and with these, national wealth. A once-for-all increase in the domestic money stock soon exhausts its positive effects and national wealth falls back to its previous level. ” In short, money illusion and sticky prices says Hume. Both effects IMO very short lived, almost trivial (recall Bernanke’s FAVAR paper, 3.2% to 13.2% out of 100%)

    So Sumner is, like Keynes frenzied madman, channeling the ideas of a 18th century Scottish polymath.

  20. Gravatar of ssumner ssumner
    16. October 2016 at 08:34

    Bill, That’s exactly what happened in 2008. Inflation was already running a bit high, then the oil shock pushed up inflation, leading to a tighter monetary policy, and then recession.

    Here’s another way of explaining things. Suppose inflation averages 2% over the long run. If it runs 3% during booms and 1% during recessions, then NGDP will be more unstable than if it is 1% during booms and 3% during recessions. Running inflation above trend during periods of low unemployment is the exact opposite of NGDP targeting.

    Kevin, I agree that tax policy is not cyclical, But our housing policies were. We had a housing boom in 2006, a period of low unemployment. The government would have been better off having the housing boom in 2009, and the bust in 2006.

    Now you could argue that we need more houses every year, but that has no bearing on the cyclical analysis in this post.

    Saturos, Thanks I have a post.

    Ray, You said:

    “recall animal spirits and people spending more”

    ROFL. You made my day, thanks for the laugh. Those are demand shocks, which only impact output if money is non-neutral.

    Once again, does the SRAS curve slope upwards?

  21. Gravatar of Kevin Erdmann Kevin Erdmann
    16. October 2016 at 08:57

    “Now you could argue that we need more houses every year, but that has no bearing on the cyclical analysis in this post.”

    It does. Your rhetorical questions imply that we built too many homes and that these still may represent malinvestment. There wasn’t a housing boom. The reason housing was procyclical was because of the bust. The idea that housing construction was unsustainable in 2006, which you seem to support, is the reason we had the recession.

    I ask again, were you building too many houses in Boston in 2006? Was housing procyclical in Boston in 2006?

  22. Gravatar of ssumner ssumner
    16. October 2016 at 09:51

    Kevin, I’m not arguing that we built too many houses or that it was unsustainable. Rather that it was unsustained. I’m arguing that policy was too procyclical.

    Monetary policy can’t increase the trend rate of growth, it can only impact the volatility of GDP (to a first approximation).

  23. Gravatar of Ray Lopez Ray Lopez
    16. October 2016 at 10:13

    @ssumner: “Ray, You said: “recall animal spirits and people spending more” ROFL. You made my day, thanks for the laugh. Those are demand shocks, which only impact output if money is non-neutral.”

    So if SRAS is vertical, not upward sloping, and people decide collectively to spend less (or more) for whatever reason, it cannot be modeled with IS-LM or AD-AS curves in your mind? Is that your claim? It’s like 0/0, undefined? You cannot have a vertical SRAS curve and people collectively changing their mind and spending more or less, which will shift AS? Is that your claim? I want posterity to laugh at you as hard as I am now.

  24. Gravatar of ssumner ssumner
    16. October 2016 at 11:45

    Ray, You said:

    “You cannot have a vertical SRAS curve and people collectively changing their mind and spending more or less, which will shift AS? Is that your claim?”

    ROFL. That’s two inanities in one sentence. Spending doesn’t shift AS, and if it did money would be non-neutral. :)

  25. Gravatar of Bill Ellis Bill Ellis
    16. October 2016 at 16:04

    Wait…the Great recession started in 2008 ?
    It officially started in dec 2007, and Oil had spiked by then… But as I remember it the economy was clearly falling apart…overleveraged… back in 2006…
    …. and the economic reckoning that was seen coming over the horizon hung over the entire Mccain / Obama elections season… before the biggest oil price surges..

    It seems to me the Oil shock was possibly the proverbial straw… but that the position our financial markets had put us in was already showing cracks…

    ….and that the depth of the recession when it finally hit was more about the great degree that our investments were invested irrationally rather than the level of inflation when the system collapsed..

    As for today I think the same kinda things need to be considered… Where is the potential for malinvestment to have it’s illusionary value exposed ?

    do we have any investment folly today that is comparable in size to the financial mess that laissez faire financial regulation released on the “greedy lazy stupid people” of america ?

    I don’t think so…I’m asking…not rhetorical ?

    if not…. even if an oil shock pushes us into a recession while we are at 3% inflation…our bottum is limited..

  26. Gravatar of Ray Lopez Ray Lopez
    16. October 2016 at 21:15

    @ssumner – you just lost me as a reader. My gosh man, if you’re willing to lie just to win a point, you’re a worthless troll (at least my posts are provocative). You say: “ROFL. That’s two inanities in one sentence. Spending doesn’t shift AS, and if it did money would be non-neutral.” But this is wrong on both counts. Mishkin’s Macro textbook, Econ 101 says and graphically shows that consumer expenditure C rising will shift the downward sloping IS curve to the right, and both Y, i will also increase. If money were neutral, as we discussed, this IS curve would be vertical, but it would still shift.

    I realize you are a busy man, and make mistakes, so I won’t publicize this little lapse of yours, it will be our little secret. Well, I won’t probably publicize it for a while, but may refer to it in the future. Two can troll too you know.

  27. Gravatar of Brian Donohue Brian Donohue
    17. October 2016 at 04:33

    Scott,

    Inflation has averaged just 1.85% per year over the past 10.5 years, but a couple years of 3% inflation would be destabilizing?

    A bit of inflation would help debtors vs. creditors. Might be more meaningful to millennials than any other policy tilt.

  28. Gravatar of ssumner ssumner
    17. October 2016 at 05:41

    Bill, No tight money caused the recession, not malinvestment, That’s something I’ve demonstrated in dozens of posts. And the motive for the tight money policy was high inflation.

    Ray, ROFL, You don’t even know the difference between IS and AS? Are you kidding me?

    Yes, please do publicize my “mistake”. Put it on the front page of the NYT!!

    Brian, If the “couple years of 3% inflation” occur when the economy is depressed, then the inflation is stabilizing. If they occur when the economy is strong, then it is destabilizing. If you are going to run a period of 3% inflation, you want to do so during a period of high unemployment. Keep your eye on the ultimate goal, stable NGDP growth. Inflation should not be the focus of policy.

  29. Gravatar of Kevin Erdmann Kevin Erdmann
    17. October 2016 at 09:44

    Scott, thinking in terms of core CPI, non shelter inflation is about 1.5% and shelter inflation is over 3%. Most of that shelter inflation is imputed. It is unrelated to monetary policy. Inflation is high because contractionary monetary and credit policies have created a negative supply shock. Do you think imputed rent inflation is high because of loosening monetary policy?

  30. Gravatar of Run the economy warm, not hot, not cold – NGDP Advisers Run the economy warm, not hot, not cold - NGDP Advisers
    17. October 2016 at 10:25

    […] Some Market Monetarists seem to be objecting to a late conversion to running the economy warmer as some sort of pro-cyclical policy that would end in disaster. It is incredibly hard to figure out how, given the low participation rate, low productivity growth, lower and lower RGDP and NGDP growth trend, can it possibly be said that the US economy is currently in anywhere near to the cycle peak. […]

  31. Gravatar of Ray Lopez Ray Lopez
    17. October 2016 at 15:50

    @ssumner – honestly, you don’t know much, so quit changing the goal posts. Clearly I meant AD. The issue here is whether an AD curve shift even if money is neutral. The answer is yes. You said: ” “Ray, You said: “recall animal spirits and people spending more” ROFL. You made my day, thanks for the laugh. Those are demand shocks, which only impact output if money is non-neutral.” Which is patently false. Even if money is neutral, you can have demand shocks that affect output, that’s what I’m talking about.

  32. Gravatar of Tim Lee Tim Lee
    18. October 2016 at 08:38

    Scott, you write “There’s not much they can do about the economy’s potential.” But how do we know the economy is at its potential? You think tight money kept the economy well below its potential between 2008 and 2010. Why couldn’t it be true that continued tight money since then has continued to keep it below potential since then?

  33. Gravatar of ssumner ssumner
    18. October 2016 at 10:22

    Kevin, You may be right, but that doesn’t really have any bearing on this post. The post is not arguing for or against a tighter monetary policy right now, it’s critiquing Yellen’s reasoning process.

    Tim, It’s very possible that the economy is below it’s potential right now. But it also seems very plausible that growth is currently above potential, as the unemployment rate has been falling for 6 years, and labor force participation has recently risen. So whatever the potential is at the moment, we are clearly either moving towards it from below, or rising further above it.

    My view is that “potential” should not play a role in monetary policy decisions, because the Fed doesn’t know what it is. But if they insist on using potential in their decision-making, the unemployment rate is probably the least bad way of estimating it. And right now, unemployment is relatively low by historical standards. According to the dual mandate, you’d want to run inflation below 2% when unemployment is relatively low, and above 2% when it is relatively high.

    In any case, even if they misjudge the potential rate of output, the economy should self-correct back to potential over time, as long as there are no new shocks. My hunch is we’ve mostly recovered, as wage growth is beginning to accelerate a bit.

    My new Econlog post might be helpful here.

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