The Fed struggles to find the right guidepost

Tim Duy has a very good post discussing the Fed’s current policy dilemma:

The drop in the unemployment rate, however, is something more of a challenge.  The Evans rule simply isn’t looking quite so clever anymore:


Monetary officials generally believed not only that 6.5% unemployment was far in the future, but also that policy would become much more obvious as we approached that target because inflation pressures would be evident.  Neither has been true.  Not only has unemployment fallen more quickly than anticipated, but inflation remains stubborningly low.

It was a mistake to put the unemployment rate into the Evans rule, it’s simply too unreliable.  We don’t know exactly where the natural rate is, nor do we know the size of the output gap.  And inflation also his its problems, as it can reflect either supply or demand-side factors, and the Fed should only be concerned with demand-side inflation.  So which aggregate is not susceptible to being distorted by either supply shocks or changes in the natural rate of unemployment?  If you have any good ideas please leave them in the comment section.  Or better yet send them on to the Fed.  Basically we

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31 Responses to “The Fed struggles to find the right guidepost”

  1. Gravatar of JohnB JohnB
    15. January 2014 at 21:43

    Haha how clever at the end there. Unfortunately, the correlation between NGDP and employment/economic stability will break down once the Fed starts targeting NGDP.

    Historical correlation doesn’t prove causation and by keeping one thing stable, other things will become less stable.

    In any case, until that day, I hope the Fed adopts your proposal because it will be truly interesting to see how it breaks down and fails.

  2. Gravatar of JohnB JohnB
    15. January 2014 at 21:44

    I should add that the correlation between output, employment, and aggregate demand is not nearly as solid as most people believe. AD is something you can measure so they are like the drunks looking under a light for their lost keys. They’d rather be exactly wrong than basically right.

  3. Gravatar of Kevin Erdmann Kevin Erdmann
    15. January 2014 at 23:31

    Inflation is low, but real wage growth is very strong:

  4. Gravatar of Doug M Doug M
    16. January 2014 at 00:10

    what do you think about the 83% capacity utilization rule? Greenspan favored it at one time.

  5. Gravatar of Daniel Daniel
    16. January 2014 at 03:57


    You left out the “individual action” part. You made Mises angry.

  6. Gravatar of Saturos Saturos
    16. January 2014 at 04:14

    I heard about this thing once, MGDP i think it was called? That could help. I think I found it on some blog somewhere. Man, was that guy really obsessed with it. Almost as if he thought it could single-handedly solve all of everyone’s problems.

  7. Gravatar of Saturos Saturos
    16. January 2014 at 04:16

    Btw Scott you should get that Enter key on your keyboard checked out, looks like it started to malfunction towards the end of that post there.

  8. Gravatar of Brian Donohue Brian Donohue
    16. January 2014 at 05:21

    Good blogging.


    Interesting analysis.

  9. Gravatar of ssumner ssumner
    16. January 2014 at 05:52

    Doug, Bad idea, it’s not a reliable indicator.

  10. Gravatar of benjamin cole benjamin cole
    16. January 2014 at 05:54

    I like factory utilization, trucking and rail indicators, architectural billings and I am sure there are more. Auto sales. Electricity consumption.

  11. Gravatar of Roger Sparks Roger Sparks
    16. January 2014 at 05:54

    Maybe we should consider whether the economy is mostly driven by supply side parameters or by demand side parameters.

    Looking first at supply side, we do not see too many true supply restrictions. True supply restrictions result from surprises like crop failure or wars. The Fed would find these events uncontrollable with monetary policy.

    Most of the economy is demand side controlled. Demand is differentiated by parameters such as color, size, durability, etc, and PRICE. PRICE is further differentiated by lowest price, next lowest price with additional options, and high end priced. It is hard to see how the Fed can expect to control this collage of factors!

    Of course, we economist DO expect some measure of Fed control by controlling money supply, interest rates and other economic factors. We economist can also see that when the Fed pushes one way, the seller or buyer may push the opposite way, for reasons of self interest or simple resistance to change.

    For examples, try to slow GDP growth with increased interest rates and the velocity of money increases. Little GDP change. Try to increase GDP with greater money supply and velocity of money slows. Little GDP change.

    Perhaps it is time to reconsider the relationship between monetary policy and fiscal policy. Perhaps monetary policy is primarily limited to supporting or enabling fiscal policy. Monetary policy may not be the simple solution to economic misallocation sought by many people.

  12. Gravatar of TravisV TravisV
    16. January 2014 at 07:31

    “Jan Hatzius: People Are Looking At The Wrong Unemployment Rate”

    “This U-6 measure of “underemployment” forms a key part of the reasoning behind the forecast offered by Goldman Sachs chief economist Jan Hatzius, who believes the Federal Reserve will refrain from hiking interest rates until early 2016, even though headline unemployment is falling rapidly.

    In a note to clients, he lowers his forecast for the headline unemployment rate at the end of 2014 to 6.1% from 6.3%, but says U-6 will keep the possibility of premature monetary policy normalization at bay”

    Read more:

  13. Gravatar of JohnB JohnB
    16. January 2014 at 08:03

    John Cochrane has a great answer that David Henderson posted over at Econlog. This makes more sense than anything else I’ve heard anyone say about the slow recovery.

    EF: What do you think are the biggest barriers to our own economic recovery?

    Cochrane: I think we’ve left the point that we can blame generic “demand” deficiencies, after all these years of stagnation. The idea that everything is fundamentally fine with the U.S. economy, except that negative 2 percent real interest rates on short-term Treasuries are choking the supply of credit, seems pretty farfetched to me. This is starting to look like “supply”: a permanent reduction in output and, more troubling, in our long-run growth rate.

    Long-term growth is like a garden. You have to weed a garden; you don’t just pile on fertilizer — stimulus — when it’s full of weeds. So let’s count up the weeds. A vast federal bureaucracy is going to be running health care and has cartelized the market. Dodd-Frank is another vast federal bureaucracy, directing the financial brains in the country to compliance or lobbying. The alphabet soup of regulatory agencies is out there gumming up the works. Then there are social programs. The marginal tax rates that low-income people face, along with other disincentives to move or work, mean that many of them are never going to work again. When the economy was steaming ahead, this didn’t really cause much trouble, but now many recovery mechanisms have been turned off. If a Martian economist parachuted down, would he not be struck by the vast number of disincentives and wedges the government places between willing employer and employee? Would he or she really say “the one big wedge between you hiring someone to make something and sell it is the zero bound on nominal Treasury rates”? Finally, uncertainty is surely a part of it. Investing and hiring has some fixed, irreversible costs, and the chance that policy could be even worse gives people an incentive to delay.

    This is all really hard to quantify, and it’s time somebody did. Unfortunately, it’s much easier to focus on “demand,” or the zero bound, or fiscal stimulus — one big magic bullet, and not the thousands of weeds.

    P.S. Daniel, I implied that individual action was more important than aggregate demand. I would never ever want to make Mises angry.

  14. Gravatar of Chuck E Chuck E
    16. January 2014 at 09:45

    John B.

    Great post!

  15. Gravatar of errorr errorr
    16. January 2014 at 10:46

    If the problem is supply side where is the inflation pressure? When will people stop fighting the previous war? The 1970’s are over and the conservative agenda proved to be a solution to our problems. This is a different world with different problems, namely demand. Show me some serious inflation and I will start to demand that supply side reforms are necessary. Until then come up with a better argument.

  16. Gravatar of errorr errorr
    16. January 2014 at 10:56

    Yglesias has a post up highlighting the fact that FED officials SAY prof. Sumner is wrong and that they are not omnipotent in their monetary offset abilities at the zero lower bound.

    While I am usually sympathetic to some of the more common critiques of the Sumner approach the arguments highlighted in the Yglesias post don’t really address what prof. Sumner is suggesting. It seems as if what they are really arguing is not some functional issue with the idea that the FED could do more, but that if they choose to do more then there are unknown risks that maybe could happen. Arguing from fear of the unknown is pretty weak although it may seem to tie their hands in a political sense.

    Seems like a strong win for Sumner, the FED gets the growth it wants because they are afraid of how more QE would affect systemic structural problems they perceive in the economy. This is just status quo bias rationalizing the economic misery of millions.

  17. Gravatar of Kevin Erdmann Kevin Erdmann
    16. January 2014 at 11:42

    Thanks Brian. I’ve updated that post with a scatterplot of real wages and the unemployment rate.

  18. Gravatar of Tommy Dorsett Tommy Dorsett
    16. January 2014 at 12:20

    As long as hourly wage growth remains modest, I think Yellen is honing in on U6 rather than U3. It, too, has fallen to a cycle low, but is falling much slower than U3 (and stands at a record ratio to the U3 rate as of December). If current trends persist, U3 will be at what is considered a full employment level in ~1.5 years while it will take ~3.5 years for U6 to fall to a “normal” level.

  19. Gravatar of Kevin Erdmann Kevin Erdmann
    16. January 2014 at 12:38


    What’s strange is that real wage growth is higher than it should be, even for the current U3 level. I wonder if it is U6 that is the outlier here.

  20. Gravatar of Tommy Dorsett Tommy Dorsett
    16. January 2014 at 13:15

    Kevin, I think this is due to a positive supply side shock: the fall in crude prices has largely been due to a big step up in USA production (and some other negative supply side forces easing up). So inflation came down and RGDP picked up. Although nominal wage gains have been steady ~2% p.a., the drop in headline inflation (due to positive supply side forces) has resulted in real wage growth moving into positive territory.

  21. Gravatar of TravisV TravisV
    16. January 2014 at 13:34

    Tyler Cowen just linked to this:

    “The effects of QE on emerging economies: a new study”

  22. Gravatar of Daniel Daniel
    16. January 2014 at 14:30


    All that talk about “individual action” cannot disguise your ignorance of fundamental matters.

    You might want to start with this

  23. Gravatar of Negation of Ideology Negation of Ideology
    16. January 2014 at 15:27


    Any comment on the annual inflation numbers from BLS today?

    For 2013, it was a whopping 1.5%. Is this the year the inflationistas admit they were wrong?

  24. Gravatar of JohnB JohnB
    17. January 2014 at 02:34


    I’m well aware of nominal rigidities and just because I look at the economy in a different way than you doesn’t make me ignorant. Call John Cochrane ignorant as well because he was expressing (better) the same view that I was expressing. However, doing so would make you a fool because he is a much more accomplished scholar than you are.

    Show me what’s wrong with my argument instead of making cowardly ad hominem attacks from behind the safety of the anonymous internet you keyboard warrior.

    P.S. The nominal rigidity story gets harder and harder to cling to as the years go by. You seem not to understand that inflexibility doesn’t mean immobility; especially now that we’ve had several years of mild inflation (and no real deflation) and a stock market boom.

    P.P.S. The fact that real wages were down for a long period after the bust yet the employment market was still sluggish does point to government interference in the labor market and supports the views of people like Cochrane (at least as quoted above, I don’t know his monetary views) and especially Casey Mulligan.

  25. Gravatar of JohnB JohnB
    17. January 2014 at 02:40

    This idea that we need higher inflation is silly. Historically, economies have been able to do very well with anywhere from mild deflation of around -2% to around 4%. Higher or lower than that is usually a sign of trouble. If we had a government that wouldn’t go around changing property rights on a whim, or implicitly promising to bail out bad firms, or wasting money on obvious losing projects and military spending that makes the world more dangerous, a lot of the problems people blame on aggregate demand or nominal wage rigidity would disappear. CPI or NGDP be damned.

  26. Gravatar of Daniel Daniel
    17. January 2014 at 03:17

    real wages were down for a long period after the bust

    Oh really ?

    And yes, John Cochrane speaks nonsense when it comes to monetary matters. He may be an accomplished scholar, but when it comes to money – he loses all reason (like many economists on the political right). Appeals to authority do not impress me.

    Show me what’s wrong with my argument

    Apart from the fact that inflation is still below trend and unemployment is still high ?

    a lot of the problems people blame on aggregate demand or nominal wage rigidity would disappear.

    I always enjoy the mental gymnastics austrians start to engage in whenever stickiness is mentioned. Yeah bro, unemployment doubled in 2008 because of supply-side factors. Sure.

  27. Gravatar of ssumner ssumner
    17. January 2014 at 09:00

    Roger, You said;

    “Monetary policy may not be the simple solution to economic misallocation sought by many people.”

    Monetary policy should not be used to solve problems, it should avoid creating problems.

    JohnB, Compare Cochrane’s predictions with my predictions over the past 5 years. What’s his explanation for the big drop in the unemployment rate last year? Why has inflation stayed low?

    Negation, That inflation number doesn’t surprise me at all.

  28. Gravatar of JohnB JohnB
    17. January 2014 at 10:10


    There’s no mental gymnastics here. It’s pure micro-level theory. Imagine Congress passed a law making the minimum wage $1000/hour. You would see a huge drop off in “aggregate demand.”

    For another example, imagine somehow all the capital goods where moved around to the wrong places. Cows and tractors got moved to New York and computers got moved to Des Moines. The collapse in employment and output would look like a demand side story to a typical economist but that would be a ridiculous explanation.


    I just liked that one paragraph by Cochrane. I’m not going to claim to have read much or endorse more of his other work.

    Inflation stayed low because bank credit is a very important part of the getting money into the economy to bid up prices and create demand-just like you talked about in the China post. With a broken banking system desperately trying to recapitalize, the loans aren’t going to be there to pyramid money off of the monetary base and create inflation.

  29. Gravatar of Daniel Daniel
    17. January 2014 at 14:33


    Thank you for proving my point. You don’t understand what “aggregate demand” means – but since it’s an important concept for “mainstream” economics, it must be nonsense. Because “individual action” and all that jazz.

    Obscurantism, thy name is Mises (& co).

  30. Gravatar of ssumner ssumner
    18. January 2014 at 08:50

    JohnB, I never claimed bank credit was important to creating inflation in my China post.

  31. Gravatar of Watch it Scott, You're Condescension is Showing | Last Men and OverMen Watch it Scott, You're Condescension is Showing | Last Men and OverMen
    16. February 2017 at 08:40

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