Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide

Thursday, September 20, 2012

Is the Fed missing on both sides of its dual mandate?

With the unemployment rate still above 8% and some inflation measures below 2%, many people argue that the Fed is "missing on both sides of its dual mandate;" see, for example, Fed Harms Itself By Missing Goals.

Jim Bullard, president of the St. Louis Fed, has a different view, which he just published here: Patience Needed for Fed's Dual Mandate.

My interpretation of  his critique is as follows.

People who make this critique invariably organize their macroeconomic thinking along "Keynesian" (or New Keynesian) lines. An important pillar of this way of thinking is some version of the Phillips Curve (see here for Mike Bryan's humorous critique of the concept). Here is what a Phillips curve is supposed to look like:

Now, imagine that the economy is hit by a large negative "aggregate demand shock." Unemployment rises, and inflation falls--there is a movement along the PC, downward, from left to right (see diagram above).

Next, suppose that the Fed has the power to exploit the PC relationship (this is a questionable supposition, in my view, but it's what people like to believe, so let's run with it). What would the unemployment-inflation dynamic look like in response to such a shock under an optimal (or near optimal) monetary policy? (Bullard references the Smets and Wouters NK model: Shocks and Frictions in U.S. Business Cycles: A Bayesian DSGE Approach.)

Bullard's suggests that a non-monotonic transition path for inflation is unlikely to be part of any optimal policy in a NK type model. The optimal transition dynamics are typically monotonic--think of the optimal transition path as a movement back up the PC in the diagram above. If this is true, then the optimal transition path  necessarily has the Fed missing on both sides of its dual mandate.

Of course, conventional NK models frequently abstract from a lot of considerations that many people feel are important for understanding the recent recession and sluggish recovery. The optimal monetary policy may indeed dictate "inflation overshooting" in a different class of models. Please feel free to put forth your favorite candidate. Tell me why you think Bullard is wrong. 


  1. David,

    The Bullard link sends us to the previous link.

  2. WSJ piece on skills mismatch that might be of interest:

    "More than 600,000 jobs in manufacturing went unfilled in 2011 due to a skills shortage, according to a survey conducted by the consultancy Deloitte...."

  3. What of shifts in the PC or changes to the slope of the PC, perhaps as a manifestation of hysteresis following a financial crisis. If such a phenomenon could be proved or at least forecasted with some reasonable degree of probability, wouldn't this support "over-shooting" the target inflation rate?

    1. Possibly. But why not get out of that armchair and send me some references? ;)

    2. Fair enough, but no time for formal citations:

      1. Blanchard and Summers 2004; and
      2. Not a paper but Plossers speech today, where he talks about how the Fed should not target unemployment, seems to apply somewhat; and
      3. Those papers on the flattening of the Phillips curve (one by the KC Fed, Tavig is it?), one by the Aussie Reserve bank

  4. Bullard argues that "US economy was hit by a large shock that reduced output and employment below historical trend values and reduced inflation substantially". This means that in his view the wealth shock from the crisis was so large that it eventually did some "permanent damage". So what started as an aggregate demand shock is now a real shock and according to the text book versions of the RBC and NK theories there is not much that monetary policy can do in this case.

    For alternative explanation, Consider the shortage of workers in construction (your earlier post) destruction of match capital. I guess this could be understood as a permanent damage to economy or a real shock. Now is there anything in the Fed's bag of tricks that could restore the match capital. How does the QE-3 rate on this criterion? According to the note circulated by Krishnamurty and Jorgenson buying MBS could lower house owner borrowing costs (http://www.kellogg.northwestern.edu/faculty/vissing/htm/MBS%20swap%20versus%20Treasury%20twist3x.pdf). A renewed demand for housing as a result might restore some of the destroyed match capital. However, this may take time as construction companies judge if this renewed demand is for here to stay or they are going to be saddled with vacant houses. So I guess we should abide by Bullard's advice. Be patient and let the economic agents figure things out!

    1. Parag, I think Bullard would agree with you entirely.

  5. This comment has been removed by a blog administrator.

  6. That first link (Betsey Stevenson & Justin Wolfers) is SO 1960s.

  7. I think this depends a lot on how seriously you take the costs of inflation. The monotonic optimal transition path arises only because higher inflation is more costly than lower inflation so that part of the cost of unemployment is offset by the benefit of low inflation in the short run. But if we suppose that most contracts in the economy are betting on the Fed hitting its target, then it could very well be that being 1% below the target is just as costly as being 1% above the target, and since the latter is associated with higher employment, it should be preferred.

    On the other hand, I think a lot of the people advocating higher inflation do so because they are positive rather than normative economists. In that case, they have a lot more faith in the prediction that higher inflation will increase employment than in the prediction that a monotonic transition path will maximize some dubious measure of well-being. I can certainly sympathize with both sides of that philosophical debate.

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