Balancing the Twin Fed Policy Mandates

July 21, 2010

The Federal Reserve is a creation of Congress and mandated by that legislative branch to promote two objectives: price stability and maximizing employment.  Because of this accountability to Congress, the Fed Chairman is required to testify before the banking committees of the Senate and House twice a year.  These appearances typically occur in February and July.  In the broadest sense, Bernanke’s task today is framed by the Fed’s dual mandate.  If the goals are not being met, he’s supposed to explain why and what monetary officials plan to do to help steer the economy back on course.

In the United States, price stability is generally considered a rate of core inflation that is near to 2%.  Most of the misses over the past fifty years have been on the upside, but deflation actually worries officials more than inflation because policy tools are less suited to resisting zero or negative inflation than to reducing inflation that exceeds 2%.  A deflationary scare in 2003, for example, prompted officials to keep the Fed funds rate target at 1.0% for a whole year from June 2003 until June 2004.  There are two dimensions to full employment: the rate of job creation and the percent of the labor force that wants to work but is not employed.

Deflation is again looming as a danger.  Core consumer price inflation in fact is lower than its trough during the scare of 2003-04.  U.S. core consumer price inflation (which excludes energy and food) was at 0.9% in April, May, and June.  That’s significantly below a rate of 1.6% when Bernanke testified this past winter.  At the summer testimonies in 2004, 2005, 2006, 2007, 2008, and 2009, core inflation was 1.9%, 2.0%, 2.6%, 2.2%, 2.4%, and 1.7%.  In mid-2003 when the Fed took an anti-deflation stance, core inflation was 2.1% and over the ensuing year got as low as 1.1% in the three months to January 2004 before starting to incline again.  Another sign of deflation can be gauged by Treasury yields.  The ultra-low 0.58% two-year yield implies very weak economic growth in 2H10 and next year, which for an economy with significant excess capacity and positive, but very low inflation, defines a plausible risk of deflation.  The 10-year yield is a better gauge of expected inflation.  At 2.93% currently, such is 57 basis points less than its one-year moving average, 133 basis points below its mid-2003 to mid-2004 average level of 4.26%, and 147 basis points below the post-1999 mean of 4.40%.

In the post-world war two era, the recent unemployment rate high of 10.1% was only exceeded by the peak of 10.8% in November 1982.  We are around one year past the start of economic recovery but just 0.6 percentage points below last autumn’s top jobless rate.  A year into the 1982-90 expansion, the jobless rate had dropped by 2.3 percentage points below the cyclical peak to 8.5%.  Three years into the expansion saw joblessness at 7.0%, and it had fallen to 5.8% at the five-year mark of the economic upswing.  The other modern business cycle that saw unemployment get as high as 9.0% was triggered by the first oil price shock and lasted from late 1973 until March 1975.  One year later in March 1976, the jobless rate was down 1.4 percentage points to 7.6%.  While unemployment was also slow to recede after recessions in the early 1990’s and early noughties, those slumps were mild with comparatively low peak levels of joblessness.  The better labor market comparisons in the present cycle are with the earlier above-cited two recessions.  Compared to those  precedents, labor market health is not getting enough policy attention.

A look at employment growth during major economic expansions of the past fifty years reveals an alarming slowdown in the rate of job creation during presumably healthy periods.  Jobs rose by 3.3% per annum from February 1961 to December 1969, 3.6% per annum from March 1975 to January 1980, 2.8% per annum from November 1982 to July 1990, but just 2.0% per annum from March 1991 to March 2001 and 0.9% per annum from November 2001 to December 2007. In this recession, the severest slump since the 1930s, the U.S. labor market suffered massive damage.  The present level of non-farm payroll jobs is marginally more then 27 million workers below the hypothetical trend level if jobs had expanded after 1999 at the pace sustained between the ends of 1979 and 1999.  In the last two reported months, private-sector jobs advanced just 33K in May and 83K in June, and long-term unemployment, which tends to self-perpetuate the longer it goes uncorrected, keeps getting worse.

The Fed deserves high marks for effort but low grades for results in meeting both its mandated missions.  A summary gauge in deflation-prone periods can be crunched by subtracting core inflation from the unemployment rate.  The higher the figure, the weaker the policy performance.  When core inflation was at 1.1% from November 2003 to January 2004, the jobless rate was 5.8% in the first month and then 5.7% in the subsequent two months.  Our composite measure of policy success ranged from 4.6% to 4.7%.  It is now at 8.6%, nearly three percentage points worse than in the previous deflationary scare.

The political environment does not at present support a looser Fed policy stance, and congress is a lightning rod for that mood.  U.S. voters are understandably frustrated with the weak economy but venting their anger against too much, not too little, macroeconomic stimulus.  The Obama administration is sympathetic to short-term stimulus.  Chief economic policy coordinator Larry Summers wrote a column in Monday’s Financial Times that concluded, “reducing the specter of prospective budget deficit will enhance near-term growth, and ensuring adequate growth in the near term will reduce long-term deficits.”  But voters and markets have stopped believing in political leadership that failed to anticipate present economic conditions.  The embrace of austerity, which is a wholly different reaction than in 2008-09,  is a contagious act of faith that must play out.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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