Saturday, February 27, 2010

Fed policy: complicating an already complicated situation

The Federal Open Market Committee (FOMC) is making tough decisions right now. Its mandate, “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”, is a seriously tall order given current economic conditions.

The unemployment rate sits at 9.7%, while prices have bounced back to 2.6% Y/Y in January. On the surface of it, inflation appears to be gaining some traction; but the big numbers are representative of base effects, and that is really all. The drag on prices remains very real.

But there is one little kink in the headline figures of unemployment that complicates an already complicated task: extended unemployment insurance. From the FOMC's Jan. 26-27 minutes:
Though participants agreed there was considerable slack in resource utilization, their judgments about the degree of slack varied. The several extensions of emergency unemployment insurance benefits appeared to have raised the measured unemployment rate, relative to levels recorded in past downturns, by encouraging some who have lost their jobs to remain in the labor force. If that effect were large--some estimates suggested it could account for 1 percentage point or more of the increase in the unemployment rate during this recession--then the reported unemployment rate might be overstating the amount of slack in resource utilization relative to past periods of high unemployment.
Why would extended unemployment benefits increase the unemployment rate? In order to claim unemployment benefits, one must be "in the labor force"; and that means looking for work. Therefore, some workers who would otherwise be classified as "not in the labor force" remain in the work force as "unemployed". Therefore, the current unemployment rate is elevated above the rate that would occur without the extended benefits. The Fed suggests this differential to be roughly 1% point.

I am in no way proposing that the extended benefits be rescinded; nor am I deluding myself into thinking that the labor market is anything short of awful. But Fed policy is calibrated to the non-inflation-generating level of the unemployment rate. And the current unemployment rate may be closer to the long-run level than the headline number suggests.

I have talked about this before (see this post) from another angle: the long-run level of unemployment may be a moving target right now, i.e., it's likely rising. Therefore, if the long-run level of unemployment is rising and subsidies are masking the true level of the current unemployment rate, then we may very well get some inflation while the economy is still weak.

Of course, I do not believe that we are even near such a threshold level; but it does complicate an already complicated situation. A modified Taylor rule demonstrates the implications for policy.

The chart above illustrates the estimated Taylor Rule using the current unemployment rate (in blue line) versus one in which 1% point is shaved off the unemployment rate for every month since January 2008 (green line). The modified rule does suggest that the Fed policy rate is currently at (or now below) the prescribed rate.

Just some food for thought. Rebeca Wilder

20 comments:

  1. Here is the employment capacity utilization graph: http://research.stlouisfed.org/fred2/series/TCU

    I would like to see that plotted against the residential and commercial real estate utilization rates. Are those series available?

    ReplyDelete
  2. hmmm...arguments can be made for 20% underemployment...

    the accumulated evidence of obfuscation in last months unemployment report are aggregated here: http://marketwatch666.blogspot.com/2010/02/lies-damn-lies-statistics.html
    (also see comment below)

    lest you miss this chart i link to: http://1.bp.blogspot.com/_pMscxxELHEg/S0c-I-I8bpI/AAAAAAAAHM0/Uq82pCCeY1s/s1600-h/EmploymentPopRatioDec.jpg

    taylor rule and similar arbitrary postulates notwithstanding, given the fact that our "labor force" is now more than half female, compared to the male workforce of the 80s, that ratio is all that should matter to the Fed...

    ReplyDelete
  3. The Fed, of course, considers the EP ratio. But this is part of the secular trend story: those industries that are heavily dominated by males (construction and manufacturing) are shrinking. This is a long-term adjustment - hence, inflation can be generated even though the remains to be a large weight of males that are out of work. Eventually, males will retrain to become nurses, teachers, and accountants (whatever). But this will take time.

    Yes, the labor market is awful - but the Fed has to distinguish between near-term cyclical unemployment, and longer-term structural issues. To be sure, near-term cyclical unemployment is obviously very much off of the mark!

    Rebecca

    ReplyDelete
  4. Hi James,

    There are measures of housing stock, population, households, and household formation at the Census - you can probably extract some output from that. The Census also releases the home vacancy rate  (it's annual, though).

    Rebecca

    ReplyDelete
  5. cant put my finger on them, but if anyone would produce charts for residential & commercial real estate "utilization rates", it would be calculated risk: http://www.calculatedriskblog.com/

    ReplyDelete
  6. I can ask Bill if he can if you want to pursue this.

    ReplyDelete
  7. Thanks Dan! If I hear anything from rjs or James, I will pass it along!

    Rebecca

    ReplyDelete
  8. Please do, Rebecca.  That home vacancy rate is quite telling overlaid with labor capacity, I'd say.  It tells a story about developers taking municipalities and lenders along for some rides. Developers have entrenched power at the municipal level which states have to address, not the Federal government.  As it is now, they had things set up to print money as long as they were making housing without actual demand, and they want more of that gravy train.

    ReplyDelete
  9. Well, maybe there is a way for the Federal government to address the problem, and maybe it's easier than the states trying to do it, because of the corruption angle.

    ReplyDelete
  10. <span>The Fed also has one additional responsibility that is not often cited, it's federal debt management activities.  The Fed must support the Treasury Market and the Federal Government's fiscal operations. There are also changes in the money supply, and legal reserves, resulting from transfers to and from the Treasury's general fund account.</span><span></span>
    <span> </span>
    <span>Purchases of government securities by the Reserve Banks (debt monetization -- increases required reserves, excess reserves, and the money supply), by the commercial banks (decreases excess reserves and increases the money supply), and by the non-bank public (an outlet for savings, retire of bank-held debt,  etc.). </span><span></span>
    <span> </span>
    <span>The Reserve banks were once allowed to purchase securities directly from the Treasury (an overdraft privilege delineated in Sec. 14 (b) of the Federal Reserve Act).   This privilege has been extended at various times...to smooth out interest rates in the money markets, and as an immediate source of funds for temporary financing in the event of a national emergency, etc.</span><span></span>
    <span> </span>
    <span>The Fed was responsible for maintaining "orderly" market conditions in the government-securities market.  It was responsible for buying and selling securities to prevent "disorderly movements,", that is, sharp, disorganized, and "unjustified" price movements. </span>

    ReplyDelete
  11. <span>There are two important factors that will influence 2nd qtr gdp. (1) The preponderance of Obama’s and the FED’s, economic stimulus will be exhausted. And (2) both of the rates-of-change in monetary lags for real-output & inflation taper off during the 1st qtr.  Money flows then turn down sharply (at the same time), at the end of April.  The economy may continue to expand in the 1st qtr, but unless additional stimulus is forthcoming, real-output in the 2nd qtr will collapse (and the stock market will tank)....Taylor like rules notwithstanding.</span><span></span>  

    ReplyDelete
  12. VoxEU has an article today:

    When will the Fed raise interest rates? Reconciling Taylor rule and financial market forecasts.

    "How long will US interest rates remain so low? This column argues that estimates using the 1993 Taylor rule are concentrating on the output gap, whereas in reality the Fed places much greater emphasis on output growth. Using an updated Taylor rule, this column favours the market view that rates will rise towards the end of 2010."

    http://www.voxeu.org/index.php?q=node/4691

    ReplyDelete
  13. Here is a copy of my comment to that VoxEU post, awaiting moderation:

    For the interest on reserve balances which the Fed has been paying since October, what is the effective overnight rate they are equivalent to?  I would say it's about 8%, based on the resultant actual observed consumer and commercial credit tightening.

    Section 128 of the Emergency Economic Stabilization Act of 2008 allowed the payment of interest on bank reserve deposits by accelerating the date that Section 203 of the Financial Services Regulatory Relief Act of 2006 (bank deregulation) went in to effect, paying banks to lend money to the government instead of their customers. Destroying more than three centuries of commercial paper lending -- failing to replace it with the much smaller Term Asset Lending Facility -- and in many locales the vast majority of shipping and commerce, that was the most regressive redistribution of wealth ever enacted by the Congress. There's more information at http://bit.ly/econFail and http://en.wikipedia.org/wiki/Excess_reserves and a petition -- if you have a U.S. zip code, please vote it up -- at http://bit.ly/TreasuryConsumersBillOfRights

    ReplyDelete
  14. james, i dont know if this helps you or not...
     i was just over at calculated risk, part of my daily routine, and searched 4Q residential vacancy, and came up with this: http://www.calculatedriskblog.com/2010/02/housing-starts-vacant-units-and.html
    theres also an embedded link that includes rental vacancies charts in that article...

    ReplyDelete
  15. Nice!  All the more reason to go in and refinance all those underwater mortgages, commercial and residential both, using Shiela Bair's asset and liability adjustment method to keep them from blowing up in bankruptcies.  It's much nicer to unwind bubbles slowly.  We should have unwound the housing bubble gently, but Paulson was having none of that.  I hope his friends who garnered their boneses on the backs of the working poor are caught in bed with him.

    If we don't unwind the commercial real estate financing problem gently, it's supposed to be about three times as big in terms as risk to lenders, so presumably we would have a double-dip recession of much greater magnitude.

    ReplyDelete
  16. Clearly the occupancy rates are key in avoiding another bubble.  Is there any way we can pass a law to get Fair Issac Co. to scale everyone's credit scores by the proportion of unoccupied housing stock?

    ReplyDelete
  17. rebecca, <img></img>a few months back andy harless caused quite a stir with this blog post: <span>The Treasury’s Monetary Policy</span>; it was dicussed on most econ blogs and maybe even MSM blogs...i wonder if you caught any of that, and if so, what you thought...the reason im thinking about it now is this new post by nick rowe @ worthwhile canandian initiative:  Shouldn't Taylor Rules include Fiscal Policy? The Fiscal exit strategy?

    ReplyDelete
  18. Hi rjs,  hadn't read Harless' article until now. As for Nick Rowe's article - perhaps this is the reason that Bernanke so often mentions fiscal responsibility. Perhaps Bernanke is suggesting what Nick Rowe has just published: that the fiscal exit should, in effect, drive Fed policy. Hence, the extended period...

    One could also argue (as per Harlass' article) that by increasing the  maturity profile, expected earned income rises, which would have a positive stimulus effect (this is part of Marshall Auerback's thesis on deficits).

    Rebecca

    ReplyDelete
  19. My position is defits is: Why would anyone or any society pay to take out loans when they could be preventing inflation by growing the middle class with the top and bottom income tax brackets?

    ReplyDelete