Uncertainty and the Fed

There’s a strange view out there that with unemployment above ten percent, and inflation subdued, the Fed should be thinking about raising interest rates.Yesterday Philadelphia Fed President Charles Plosser attempted to explain his view:

… several empirical studies have shown that economic slack is difficult to measure with any accuracy. So making policy decisions based on measures of such slack and particularly on forecasts of slack many quarters ahead becomes problematic.

Plosser is right that there’s uncertainty about the exact degree of slack. But his conclusion — that this builds the case for raising interest rates sooner rather than later — just doesn’t follow.

The standard view is that “economic slack” (which is really just central-bank-speak for unemployment) is important because a depressed economy means that workers don’t have the power to ask for higher wages, intermediaries won’t raise input costs, and firms find their profit margins under pressure. Enough slack yields low and stable inflation. Too much slack — as we surely have right now — leads inflation to fall.

Because high unemployment will likely persist for several years (and Plosser himself sees unemployment edging up further), most forecasters believe there’s barely any chance of a serious inflationary episode in the next couple of years. But Plosser argues that we need to take account of the fact that economic slack is difficult to measure, adding uncertainty.

How does uncertainty change this analysis? Either there’s more slack out there than we think, or there’s less (or current forecasts are spot on). Balancing these risks means thinking through the consequences of each outcome. If there’s really less slack, then inflationary pressures may well arise at some point. If this happens, the policy “mistake” of interest rates being too low in 2010 could be easily undone by higher interest rates in 2011. But what if there’s actually more slack out there than we think? If this occurs, future inflation will not only be low, but it may fall to the point that deflation may become a real risk. The problem is that this mistake is not easily undone; excessively high interest rates in 2010 can’t necessarily be undone by lower rates in 2011, because interest rates can’t fall below zero. In fact, this “zero lower bound” is what made both the stimulus package necessary as well as the Fed’s current unconventional monetary policies.

Plosser is right — there’s definitely uncertainty about the inflation outlook. But the consequences of raising rates too early are just a heckuva lot harder to undo than the consequences of raising rates too little or too late.

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  1. jonathan says:

    What if there’s less slack and raising rates drives the economy back into recession? What if raising rates actually hurts our ability to sell long-term US debt because the buyers would now fear rate increases well before unemployment drops? What if raising rates pumps up the dollar enough that exports are hurt? I could list more but almost all come out against raising rates now.

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  2. aaron says:

    What if raising rates keep the goverment spending from growing and brings long term rates down where they should be.

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  3. Eric M. Jones says:

    “… several empirical studies…”

    Wait a minute…either it’s “empirical” or a “study” but not both.

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  4. Matt says:

    It seemed to me that a key part of his argument is that the Fed’s ability to control inflation is intimately tied to it’s credibility regarding it’s ability and desire to control inflation. Gold surging past $1200 suggests that credibility is in question.

    Doubts about the ‘standard view’ of macroeconomics are not confined to problems with measuring the output gap and are one of the reasons the Fed is in danger of losing whatever credibility it has left after it’s utter failure to perform it’s duties over the last few years. The economic slack issue appears to be the least important part of his argument to me.

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  5. Mark says:

    Re: Comment #2… There is no evidence to show that government spending would slow if rates are raised. Congress has a funny way of continuing to spend without regard to [anything, interest rates included].

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  6. Tom says:

    I might be wrong on this, but the only justification that I could see for this viewpoint is that there’s a fear of growing inflationary expectations. If recent measures show inflation growing despite high unemployment, then perhaps people’s expectations of inflation have shifted out, so to speak, and the fear is that even greater inflation will be necessary to produce short-term reductions in unemployment.

    But I would counter with the fact that for all the uncertainty around the unemployment rate, there is probably considerable uncertainty around the inflation rate. The Philly Fed provides data sets on historical revisions in economic statistics, and I’ll be interested to check on the comparative standard errors on the two statistics.

    All that said, you’re right. Rising inflation can be fought with higher interest rates, and presumably a few quarters of higher interest rates would fix people’s expectations. However, potentially putting more people out of jobs in the short run by raising interest rates would likely be much more difficult to reverse.

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  7. Doug says:

    Gold prices, like $140 a barrel oil futures prices, are a reflection of too much money in the hands of the wealthy, not of inflation. This is where the $1.5 trillion in tax cuts that Bush pushed through the Senate via reconcilation has gone.

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  8. Mark Anderson says:

    There will be no economic recovery until the Fed DOES TIGHTEN.

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