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.


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.


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

Eric M. Jones

"… several empirical studies..."

Wait a minute...either it's "empirical" or a "study" but not both.


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.


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].


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.



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.

Mark Anderson

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


Enough slack yields low and stable inflation.

Really? Ever heard of stagflation? Ever seen crises in developing countries?
I thought "Freakonomics" is supposed to rely on facts, not on what textbooks say.

Jose Gomez Rodriguez

Jose Gomez Rodriguez. Freelance Think Tank.


Even at an interest rate of zero, the Fed can choose to tax bank reserves (pay negative interest). This and other techniques are known and have been discussed by Bernanke, Mishkin, Woodford, Svensson, etc. Why we needed the stimulus when the Fed didn't exhaust standard monetary opportunities and (in Fall 2008) and sterilized their interest policy by choosing to pay banks interest on reserves will forever remain a mystery. The latter policy should be reversed today and the banks should be pushed to lend.

In contrast, both the timing and nature of the fiscal stimulus is so contrary to even the most orthodox Keynesian theory (too much long term stimulus, too political, too targeted to low unemployment states, too slow to be spent) that I'm amazed anyone at Chicago could have preferred it over a more expansive Fed in 2008 and 2009.


I thought I'd clicked on the wrong bookmark in my browser and got Krugman's blog. I'm not angry, just saying.

science minded

This is very complicated, but I do have a question.I have heard nothing about increasing the tax on imports i.e., making it in the buyers real interest to buy whatever is made in America? Wouldn't this put more Ameircan workers back to work? LEt's be somewhat hypothetical. I bought a car about 8 months back-- a used one "as is" and from I know now-- a lemon. So-- I decided to buy a new one from the same company recently - take my losses. Sure I have a reason-- my daughter is getting her license soon and I don't want her driving this unsafe car for which the lemon laws don't seem to apply. Now-- I could buy an American car. Frankly, that is not my preference at the moment-- but If there were an equivilent American made hybrid-- similar in its Euopean/foreign look, sporty and the price was right i.e., the price of buying a new car from an American company were within or less than what I am paying now and the service good or better than what I am now getting now (assuming the same low interest rates that allows me to pay it off over 5-6 years) and the price of a foreign car (with import tax) was so high (out of my league) -- I would definately buy American-

What now is my incentive? The idea is not enough- I need real incentive.


ray bans on my face

First off, comment #10 smacks of the rhetoric employed by Ron Paul and his idiot congressional counterparts, as well as their supporters. If Ron Paul ran things in the U.S., and then had his way, this country would've been up to its forehead in s**t a long time ago. Don't ever forget that the independence of the Federal Reserve has been a great contributor to the economic strength and standard of living in this country. If the Fed had to go through Congress every time interest rates needed to be raised or lowered, then the Fed's decisions would be the product of nonsensical persuasions that flow throughout Congress, not to mention decisions for interest rate increases and decreases would take WAY too long. If we got rid of the Fed and left the responsibility of maintaining the economy to others, most likely the politicians that demonstrate little or no knowledge of economics (like Ron Paul), then our economy would plummet, and you know it. And all this jabber about the devaluation of the dollar is reminiscent of the alarmist rhetoric I hear on all the news channels. Do you seriously think that the devaluation of the dollar is necessarily a bad thing? Even if the dollar's value goes down it will still buy goods and services. In fact, it's still pretty strong in international markets. When the value of the dollar goes down, U.S. exports become more attractive to other countries, thus making the U.S. export industry more competitive. But in the end I guess it sucks if you really do need to own a BMW. Sure, some foreign investors will take flight with their capital, but there will still be plenty of them left because THE U.S. IS STILL AN ATTRACTIVE PLACE TO INVEST. You seem to forget that many industrialized countries are currently going through recessions, just like us. And even still, the U.S. is still in pretty good condition relative to lots of countries. Oh, by the way, did you know that Paul Volcker engineered a deep recession to drive down inflation back in the 70's and get the economy back on track? The situation he had to deal with back then was different than what Bernanke has to deal with now, because there is more at stake. Just sayin' dude...

The Fed is in a tough position, and like Plosser and Wolfers I agree that the consequences of raising interest rates now can exacerbate unemployment and perhaps dip the U.S. economy back into recession; but how severe I am not too sure. I do not think that inflation has become so problematic that the price levels of all goods and services have exploded. Since raising the interest rate combats increasing price levels by making saving more attractive, I don't see too much of a need for it. But in the near future, I think that The Fed should raise interest rates by a fraction of a percent, and slowly raise it just like that from then on if unemployment and GDP begin to move with each other again (GDP up, unemployment down).


science minded

So is the problem with taxing imports-- fear of retaliatory measures by others? Perhaps this would have a reverse effect in China. And if we need to raise cash to pay back our debts-- selll grade A, US Bonds. Let me be clear and straightforward. I own a Toyota and until this most recent incident of buying a used car from them, their service was great and high end. I kept my previous car 10 years and it was slightly used when I bought it. I don't need to buy a Toyota- and would not be buying a new one (if I did not have a child driver in the family) but the mileage now is phenomenal and the service usually quite good. I want to buy American- just have not found the right car, servicing station. so my thought is- perhaps American makers ought to take a look see at what others are doing that we are not. Actually buy the car, test it, use their service and see what I mean. (Another Soc 101 experiment) And then improve upon it. Cause as I said before, I would prefer to buy an American car.

Some large chain grocery stores are selling more American products (farm goods) lately. They let you know up-front and its a pleasure to see american farm products more easily available in stores and not just in flee markets..

So when it comes to American manufacturing-- I say GET A GRIP!



so the philly fed prez is a shill for moneyed investors- so ironic that the real problem with our economy starts at the top

Mark A. Sadowski

Charles Plosser helped to coin the term Real Business Cycle Theory.

The RBC school doesn't believe in nominal shocks. Thus they don't really believe in the concept of "unemployment." In their view the only focus of monetary policy should be price stability.

I agree with jjn (#11) that more could be done to fight the recession in the form of inflation targeting and quantitative easing. It's precisely because of fed economists like Plosser that more has not been done. In addition to the names jjn mentions I recommend Scott Sumner of themoneyillusion.com.

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