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.