Friday, September 25, 2009

The Fed's moving target: NAIRU

This is the article that I wrote on Angry Bear today.

Neal Soss and Henry Mo at Credit Suisse published a very interesting article, "Where is full employment in a more volatile macroeconomy?", where they argue that the natural (long run) rate of unemployment may be shifting (they do this by showing that the Beveridge curve, which plots the the job vacancy rate against the unemployment rate, is shifting upward). I cannot provide a link, but here are their conclusions pertaining to monetary policy:
In the case of rising NAIRU [RW: this is the rate of unemployment that does not grow inflation, often called the long-run rate] and higher economic volatility, the monetary policy implication is complicated.

On the one hand, a higher NAIRU suggests that it would require a strong and prolonged recovery for the unemployment rate to return to the level attained in the past two decades. This scenario argues for a long period of low interest rates, because the economy’s structure will make it harder to get unemployment back to the low levels of recent business expansions.

On the other hand, a higher NAIRU suggests higher inflation pressure, as the output gap is smaller than otherwise would be the case. In other words, the Fed would have to normalize its policy stance sooner than would have been the case warranted by a stable NAIRU.

The burden of this is likely to be several years of quite low short-term interest rates by any modern standard other than the zero-ish levels of today. Even if the NAIRU is deteriorating, it is likely to be several years before the economy generates enough of a drop in unemployment to get to the new NAIRU, presumably above the levels of the last 20 years but surely below the current 9.7% unemployment rate. Between now and then, high unemployment is likely to remain the focus of policy attention. Labor market policies, such as job retraining for the unemployed, to improve the inflation unemployment trade-off, would make the central bank’s job a lot easier as that longer-run unfolds.
Basically, if the long-run level of unemployment, which the Fed targets implicitly under their dual mandate (maximum sustainable employment and stable prices), is changing then the Fed’s job becomes that much more difficult. Policy is only as good as the model’s calibration: they need to confidently estimate and target a level of employment that may be very much in flux. A simple Taylor Rule estimation illustrates this point.

Note: The Taylor Rule is a policy rule that relates the federal funds target to inflation and the output gap: roughly speaking, as inflation rises relative to the output gap, the Fed should tighten (raise its target); and as the output gap rises relative to inflation, then Fed should ease (lower its target). I estimate the relationship, and you can view my data here, and Wells Fargo's forecast here.

On one hand, the CBO projects that NAIRU is 4.8%. In this case, the Taylor Rule policy drops the fed funds target to -4.6% by the end of the year. Put it this way: the output gap is so big that policy is very, very aggressive but bound by zero.

On the other hand, if NAIRU has shifted to something more like 6% - this is roughly its level in the 1980’s - then the policy prescription is less aggressive. The output gap remains wide, but the implied target rises to -3% rather than almost -5% - still negative, but suggestive of a more benign policy strategy. Inflation pressures would start to build earlier than under the 4.8% case.

This complexity has been documented by the Fed in the minutes of their August 2009 meeting:
Though recent data indicated that the pace at which employment was declining had slowed appreciably, job losses remained sizable. Moreover, long-term unemployment and permanent separations continued to rise, suggesting possible problems of skill loss and a need for labor reallocation that could slow recovery in employment as the economy begins to expand.
Note: this not the same thing as a jobless recovery – the unemployment rate may very well fall with economic growth (no jobless recovery), but then settle at a structurally higher level.

Rebecca Wilder

P.S. I will not be able to respond to comments until tomorrow.


  1. Hey,
    If one of the FED's mandates is stable prices, I would ask wjat grade (A-F) they get for the last 11 years. Bear in mind Nasdaq 5000 and homes in las vegas at 1 million dollars (yours now for $250k). How many times can you fail a class anyway?

  2. "All monetary policymakers now understand what the academics call "Taylor's Rule" (due to John Taylor) -- when inflation increases and market interest rates rise with that inflation, the central bank must increase its target rate by more than the increase in market yields -- else, the central bank is just keeping abreast of the market and not leaning against the inflation. If such a rule is approximately correct, then it should also moderate the growth of the base and reserves (which of course are feeding the inflation)."

    "The Fed's staff are all very sensitive to the Fisher equation and its implied spread between nominal market rates and "real" rates. Every economics class has taught about the Fisher equation for decades.

    But, of course, there are open issues -- which maturity of nominal rate to use? And which price deflator? Some folks would use an overnight rate, some a 90 day rate, some a government rate, some a private sector rate, some would use the 10-year bond rate, etc...... "

  3. A dual mandate is impossible:

    It isn't within the power or responsibility of the Federal Reserve to hold unemployment or even Gross Domestic Product to "tolerable" levels.

    In fact, to assume that the Federal Reserve can solve our unemployment problems is to assume the problem is so simple that its solution requires only that the Manager of the Open Market Account buy a sufficient quantity of U.S. obligations for the accounts of the 12 Federal Reserve banks.

    This is utter naivete.

  4. Can someone direct me to the data set that confirms that there is a causal relationship between unemployment and the rate of inflation?

    I agree with Flow5, the Fed can't simultaneously influence both prices and employment.

    While the Fed can strongly influence short term rates, it is far less successful at the long end of the yield curve.

    The money supply consists of two components, currency and credit money. The Treasury has responsibility for the currency, even if it is a Federal Reserve Note. The Fed has the authority to control the quantity supply of credit.

    Rather than attempting to mess with prices, the interest rate, they'd be far more effective if they focused on the level of required reserves in two parts. First as to required reserves versus deposits; second, as to tangible net assets, the bank's equity position.

    At some point the dialogue has to address the core problem, profligate spending funded by irresponsible lending. A very important element in the needed dialogue is the recognition that since 1971, the dollar has been incapable of functioning as a store of value. This fact is the implicit and extraordinary motivator toward spending. "Spend it today, it'll buy less tomorrow".

    There are no good options here, but we must ultimately do the following: erase the too big to fail doctrine, eliminate the banking oligarchy by forcing the breakup of institutions that are functioning as both fiduciary deposit takers and as invetment banker; that is, reconstitute some form of Glass-Steagell, and recognize that financial derivatives, even when used as hedging vehicles, are nonetheless, speculative instruments and by that fact must be subject to regulation as is the case for commodity derivatives.

    Finally, as a society we must identify what it is that we can export so as to have an offset for all that we import.

    If we fail in resolving this mess, we will see our standard of living fall while that of our trading partners rises. Clearly, we have everything to lose whereas they have everything to gain. The differential is extremely large and we will lose far more than our trading partners gain.

  5. Hi Siggy and Flow5,

    You both bring up good points about the dual (actually the mandate is threefold, including supporting moderate long-term rates, which is more of a subset of stable prices). The fact is: that the Fed can only support these objective through the catalyst of the credit markets, therefore, supporting the employment objective is indirect at best.

    Many global central banks with an inflation target do have the promotion of employment written somewhere in the objectives, but is not the official mandate.

    By the way, this crisis has shown the canyon-sized holes in the Fed's final but much less visible role: promoting health in the financial system. This role is critical, and needs further scrutiny.