The Fed subtly absolves itself

The Fed has a dual mandate: price stability and maximum employment. It has failed miserably regarding the latter. It therefore argues that unemployment is “structural”. Tim Duy has a long post discussing the issue:

Given that thoughts of high structural unemployment continue to emerge in Fed thinking, the topic bears ongoing scrutiny.

He refers to David Altig research director at the Atlanta  Fedwho in a recent post argued:

So, relative to recent experience, at this point in the recovery GDP growth and employment growth are about average (if we ignore the size of the recession in both measures). The undeniable (and relevant) human toll aside, the current recovery seems so disappointing because we expect the pace of the recovery to bear some relationship to the depth of the downturn. That expectation, in turn, comes from a view of the world in which potential output proceeds in a more or less linear fashion, up and to the right. But what if that view is wrong and our potential is a sequence of more or less permanent “jumps” up and down, some of which are small and some of which are big?

I think this is a “scandalous” paragraph. “If we ignore the size of the recession in both measures”! But that´s the crux of the matter, not something to be “ignored”, as I will  show.

And the discussion moves to marshalling “intangible” evidence in the form of “estimates” of “potential output”. From Duy:

The implication is that perhaps we are closer to potential output than is widely believed.  Now, before you roll your eyes, as I am inclined to do, note the CBO estimate of potential output is not the only estimate.  Menzie Chinn reminds us of the variety of estimates of potential output, some of which suggest that, at the moment, the output gap is actually positive(!).

And quickly the Fed creates a “parallel world”. From the most recent FOMC meeting we read:

Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy’s level of potential output . In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets. (Emphasis added).

Other Fed researchers are more sanguine. Mary Daly at the San Francisco Fed shows that contrary to what a “structural” explanation of high unemployment/low employment would suggest, it is broad-based. Also, according to her, the behavior of wages, which shows a pretty uniform pattern across all sectors is not consistent with a “structural” explanation.

I´ll use the “output gap” strategy to show that the reason for high unemployment/low employment is most likely due to lack of demand, i.e. nominal spending.

As a measure of the output gap I take the mean of the gap estimated by the CBO and John Cochrane´s “consumption based measure”. The figure shows what transpires. Mostly it conforms with the cycle peaks and troughs determined by the NBER (2001 is a notable exception).

The figure below shows that while in the 1960´s and 70´s the gap preceded and was closely correlated with inflation, that relation disappears during the “Great Moderation”, i.e. inflation was “conquered”.

The next figure relates the output gap to changes in employment (NFP).

Why, one will ask, for a comparable gap in the 1981/82 recession the drop in employment in the 2007/09 recession was so much bigger?

The answer “spits in your face” when you look at the next graph, which shows the plunge in nominal spending growth after mid 2008, something that was last seen in 1938! Since that didn´t happen in 1981, the drop in employment was much smaller and short lived.

Analysts insist on looking at different components of NGDP to figure which would most likely “support” demand. An example from Duy´s post:

Also arguing for a largely demand side explanation to the current weak employment numbers is what looks like a pretty obvious link between asset bubbles and full employment over the last decade.  As long as households had a mechanism to support demand, achieving full employment was not a problem.  If not households, then why can’t another form of demand fill the gap?

Which takes me to one of Scott Sumner´s first posts, back in February 2009, aptly titled Grossly Deceptive Partitioning:

Economists often flounder around seeking the mysterious cause of the drop in AD after late 1929.  Did consumers suddenly stop spending?  Or did a change in animal spirits hold back investment?  The answer is much simpler, as with any decline in nominal spending either the monetary base declined, base velocity declined, or both.  In 1930 it was both.  The various components of GDP will respond in different ways to the lower nominal spending under different conditions, but they don’t add any explanatory value.

So don´t believe for a minute that the Fed is “not guilty”!

3 thoughts on “The Fed subtly absolves itself

  1. I won’t believe it. The Fed is guilty, guilty, guilty.

    And for some icing on the cake, here is Lacker today: “The Federal Reserve should remain on the sidelines because any more easing at this point would boost inflation but not growth, a central bank official said Thursday.”

    BTW, does the Fed ever truly “remain on the sidelines”? Doesn’t holding their present position the same as doing something, when it comes to monetary policy?

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