Never reason from ‘output gaps’

Normally Tim Duy is a very sober ‘Fed watcher’, commenting on the likelihood of the Fed deciding one way or the other, etc. But in this post I could picture him typing with ‘trembling hands’ and ‘quivering chin’, all the time thinking “this is not the world I live in”.

Has the pursuit of low inflation brought us to a point where we can maintain the Fed’s dual mandate only at the presence of financial instability?   That unless we allow for somewhat higher inflation, we are making a deliberate choice to follow only “inflation-neutral” measures of the output gap and ignore “finance-neutral” measures?  And, importantly, might it not be the case that the costs of somewhat higher inflation are in fact less than the costs associated with the financial instabilities that seem to be part and parcel of the current low-inflation regime?

Bottom Line:  If Kocherlakota is correct and monetary policy can only pursue the dual mandate in the context of financial – and, by extension – macroeconomic instability, then we really need to consider which part of the dual mandate needs to be loosened to reduce the reliance on financial instability.  My fear is that if Fed policy makers were asked this question, they would unanimously answer that it is the full-employment portion of the mandate that should be jettisoned.

My oh my!

2 thoughts on “Never reason from ‘output gaps’

  1. It seems to me that the Fed decided several years ago to forget all about the legislative mandates and do its own thing even before the financial crisis. And it keeps refining what that one thing is – first inflation, now bubbles and some vague notion of ‘financial stability’. Perhaps tomorrow it will be the price of oil or the number of coconuts consumed on a daily basis (can’t have the population getting the runs from too many coconuts!). My opinion is that too much is made of statements like these by the various Fed idiots instead of insisting they be forced to follow the law. After all, the FOMC is vested with a delegated responsibility of Congress – and we need to pressure Congress to put a stop to the merry-go-round of inappropriate monetary targets and refocus on the Fed on the law.

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