OFFICIALS at the Federal Reserve, a few of them anyway, seem to be rethinking their views of the economy in some dramatic ways. In a new blog post, however, Ben Bernanke suggests that Fed watchers shouldn’t overstate the radicalism of the intellectual evolution within the Fed. Top policy-makers still have confidence in their mental model of the economy; they have just been tweaking a few of the parameters within that model, he says. In particular, the Fed’s long-run projections for GDP growth, the unemployment rate and their benchmark interest rate have all been revised down (see table).
As Mr Bernanke notes, these revisions change the outlook for rate rises in slightly different ways. The latter two—a lower unemployment rate and a lower long-run interest rate—clearly imply that rates will rise more slowly to a lower overall level. The projection of a lower potential growth rate, however, is more ambiguous. It suggests, for instance, that the American economy is running closer to its “speed limit”, or the pace of expansion at which inflation pressures begin to build up. That, in turn, could push some members toward a more hawkish stance.
The interesting thing to me, however, is that these three revisions are not created equal. Two of them are clearly justified by the trial-and-error policy moves of recent years. The Fed thought the equilibrium unemployment rate was between 5% and 6%, for example, but found that unemployment could go well below that range without generating runaway wage inflation. Their earlier guess was clearly in error and in need of revision. Similarly, the Fed’s attempts to normalise policy—by ending asset purchases and then beginning rate rises—have run headlong into an uncooperative market. Under normal circumstances, we would expect Fed guidance about looming rate rises to push up long-term interest rates, since long rates are partly made up of cumulated short rates. Yet whenever the Fed has tried to communicate to markets to expect looming rate increases, both long-run interest rates and expectations for future rate increases have declined, indicating that such moves would threaten to push the Fed’s benchmark rate above the equilibrium level, slowing the economy and requiring subsequent rate cuts. Again, the evidence suggests that a revision is needed.
The change to the third parameter is different, however. Available evidence is consistent with a world in which long-run potential growth has fallen. Low interest rates could reflect low underlying productivity growth, which could also explain why there has been lots of hiring (and falling unemployment) despite disappointing GDP growth. But the available evidence is also consistent with an economy which is growing slowly because of too little demand, and in which both strong employment growth and low productivity growth are side effects of the low level of wages. The only way to resolve the question in a satisfying way is to test it: to push the economy beyond the estimated potential growth rate and see if inflation rises. The Fed might then discover that potential has fallen, and that even a small acceleration leads to rapid price increases. But it might instead discover, as it did with the unemployment rate, that the economy sails right through what the Fed thought was the speed limit without much overheating at all.
Mr Bernanke argues that Fed officials are willing to be a little patient with the economy, to see whether running it a little hot brings more workers into the labour force and encourages productivity-enhancing investments. It certainly seems clear to me that overshooting is the right way for the Fed to err. On the one hand, you’ve got a little more inflation than you thought you would (hardly a tragedy given that the economy has had far less inflation than it ought to have had over the last half decade). On the other, you’re sacrificing untold economic potential by allowing the economy to run with a persistent demand shortfall. That seems like a pretty easy call to me!
But I am less confident than Mr Bernanke in the Fed’s openness to overshooting. It did not exactly intend to run the unemployment rate experiment that demonstrated how run its previous projections had been; fortunately for the American economy, the unemployment rate fell much faster than anyone had anticipated, catching the Fed off guard. Now, the Fed looks all too willing to revise down its GDP growth projections without ever really testing them, and it began its cycle of rate increases (which may eventually include more than one) despite a rate of inflation well below target.
I am worried that Mr Bernanke is right. There is far too little radicalism at the Fed. It risks making permanent a low-growth state of affairs which is largely a consequence of its own excessive caution.