Fed Official says: The problem is structural. There´s not much monetary policy can do to help revive the economy.

He´s back again with his “it´s structural” meme. In 2010, less than a year after becoming president of the Minneapolis Fed, Kocherlakota made a speech in which:

  1. He argued that unemployment was structural and
  2. That if the Fed Funds rate was kept at zero the appearance of deflation was only a question of time!

With regard to (1) he said:

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

With regard to (2) what he meant was something like:

With the federal funds rate near zero since December 2008 and expected to remain there for the next year or two, the Fisher equation has important implications for the expected inflation rate. If the real economy is currently rebounding to a sustainable growth trend, the real interest rate will rise and the only outcomes possible will be either a higher nominal federal funds rate or a negative expected inflation rate…

The operative word is IF, and two years on we know the economy has not rebounded – climbed out of the hole into which it dropped after mid-2008.

So recently Kocherlakota, to be consistent, said that:

MINNEAPOLIS (Reuters) – Unemployment may not have too much farther to fall before inflation threatens, forcing the U.S. Federal Reserve to respond by raising interest rates sooner than expected, a top Fed official said on Thursday.

The fact that inflation continues to run above the Fed’s 2-percent target, Minneapolis Fed President Narayana Kocherlakota told the Economic Club of Minnesota, is “a signal that our country’s current labor market performance is much closer to ‘maximum employment’ than the post-World War II U.S. data alone would suggest.”

The U.S. central bank’s monetary policy “should be responsive to such signals,” he said.

At least he dropped his “low interest rate-spells-deflation” sequence. And his “it´s structural” follows from his reading of the Beveridge Curve, a creation of Lord William Beveridge who wrote the Beveridge Report of 1942 which paved the way for the development of the British welfare state.  The Curve establishes a negative relation between the rate of job openings and unemployment, grounded on idea that if the unemployment rate is elevated firms would find it easier to fill vacancies. If that doesn´t happen, it means that the curve is shifting up, indicating that firms have greater difficulty in filling vacancies.

This could be due to several factors, among them greater difficulty in matching workers to jobs and the persistence of long-term unemployment (which may “depreciate” human capital and/or increase “negative perceptions” about the unemployed by potential employers).

The “mismatch” view is difficult to reconcile with the observation that, with the notable exception of the Leisure & Hospitality sector, employment most everywhere is still way below the pre-recession peak, even though we´re almost three year into the “recovery”. And in no sector are wages differentially rising to indicate that labor demand outstrips supply.

Maybe the high rate of long term unemployment is the main factor behind the Beveridge Curve dynamics. Pity that the JOLTS data only begins in late 2000, so we cannot compare present behavior with that observed, for example, in the deep recession of 1981-82.

The point is that there are always “structural” elements present in the unemployment rate observed. After all, the economy is permanently in motion and all sorts of “frictions” are present. But I believe that for most situations the strength of aggregate demand will help in the adjustment process, so I´m willing to bet that in the early eighties we would not be discussing, like now, about the “structural” nature of unemployment. While between 1982 and 1985 aggregate demand grew on average 10.6%, since 2008 it has only expanded at 2.9%, barely more than half the 5.6% growth observed during the twenty years of “Great Moderation” (1987-07).

So, while in the early eighties long term unemployment averaged 18.7 between 1982 and 1985, it has averaged 35.1% since 2008, having remained above 40% for the last 28 months.

In his most recent speech, Kocherlakota introduces new elements of analysis:

Labor market outcomes do remain notably worse than prior to the recession. The good news is that the unemployment rate has been declining since the end of the recession. But there is also countervailing evidence: The labor force participation rate has been falling steadily, and the employment/population ratio remains near its low point. The Beveridge curve shows considerable deterioration in labor market matching efficiency.

How persistent will these changes in U.S. labor markets prove to be? Economists hold at least two views on this question. The first is guided by the patterns in post-World War II data for the United States. These patterns suggest that the current deterioration in U.S. labor market performance is indeed reversible under appropriate policy.

The second view is less sanguine. It says that the post-World War II data do not contain an economic crisis of the kind or magnitude that hit the United States in 2008. Such a crisis could well have a different kind of impact on labor markets than the earlier postwar recessions.

But he fails to make the connection between the magnitude of the crisis and monetary policy. This connection comes out very clearly in the chart below which shows that for the first time since 1937/38, during the second leg of the Great Depression, nominal spending (NGDP) growth – a magnitude directly determined by the Fed – turned negative, and significantly so!

The “Kocherlakota view”, based on NAIRU – Non Accelerating Inflation Rate of Unemployment – is being picked up elsewhere. The latest issue of the Economist drums the same beat:

But there is another, more troubling possibility: the crisis may have permanently dented America’s productive capacity. If so, the “output gap” between the economy’s current level of production and its potential level is much smaller than expected. Unemployment has fallen because there are fewer people available to work. Inflation is stable because there is less idle capacity to restrain prices. This would be bad news all round. America would be permanently poorer than would otherwise have been the case. The Federal Reserve would have less room to ease policy before inflation revives. More of the budget deficit would be structural, rather than the temporary result of a depressed economy.

As Adele sang: Let´s keep “Rolling in the deep”. To many, there´s now basically nothing monetary policy can do to help the economy come out of the deep hole that bad monetary policy pushed it into!

3 thoughts on “Fed Official says: The problem is structural. There´s not much monetary policy can do to help revive the economy.

  1. Actually, with regard to (2), Kocherlakota is wrong even if the natural rate is high. The real rate is lowered whenever the the Fed increases the rate of monetary growth (increasing the supply of loanable funds), which brings down nominal rates too for given expected inflation. Of course if you increase money growth then expected inflation would tend to rise. But you can always peg the interest rate as low as you like and keep increasing money growth to keep it. A high “natural rate” does not require deflation in order to keep the nominal rate low – the Fed doesn’t cause the rate of inflation by setting the nominal rate relative to the real rate and then waiting for the Fisher effect! No, the Fed sets a low nominal rate by setting the real rate even lower. Then the “natural” nominal rate is high but the Fed keeps it depressed by continuing to raise money growth. So pegging the nominal rate at zero whilst the natural rate rises doesn’t cause deflation, it causes hyperinflation! OTOH if the natural rate is negative (like now) due to low NGDP expectations, then pegging the nominal rate at zero doesn’t lower the real rate to equilibrium, so it’s too high and we have disinflationary unemployment.

  2. Were monetary policy not being held back, not only could unemployment (as currently measured) come back down to at least 6 percent, most people who have only been out of the labor market for a year or so could once again find work. Just as importantly, people with student loans could gain work to repay those loans. However the people I am most concerned about are those who have not had employment for more than a year and their formal education is sketchy in recent years. It is equally important that these individuals also be reintegrated into the broader society.

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