The new Federal Reserve chair just had a stellar inaugural news conference, and kudos to her. I said months ago that she was the “safer” choice, and I think President Obama deserves credit for appointing her. With that said, there is a subtle danger in the language she is using to describe how the central bank now sees the economy and understands the limits of its power.
POLITICO describes the shift:
The Fed has previously said that the magic number for when it might begin to consider raising short-term interest rates is when unemployment hits 6.5 percent. But with that number within reach — it currently stands at 6.7 percent — Yellen and the Fed simply dropped using the target as an indicator, instead referring to more vague “labor market conditions.”
This is an error. What seems rather tiny is in fact an exponentially risky shift away from neutrality.
In terms of monetary policy, the national rate unemployment is the indicator that matters, not the alternative metrics like EPOP and LFPR that are, in my own words, more accurate assessments of how the people in the economy are experiencing the labor market. Why the contradiction?
Because there are limits to what gunning an engine can do.
Monetary policy is one, giant lever in managing the macro economy. A good metaphor is the gas pedal on an automobile. You push harder, the car goes faster. But no matter how hard you push the gas pedal, the engine’s design will not change. In this metaphor, engine performance is the equivalent of fiscal policy. Business regulations that are rooted in the 1950s worldview will perform, metaphorically, like a car engine from the 1950s. And when fiscal policy degrades the engine’s quality – reduces the number of cylinders, cuts a few wires, uses cheaper gasoline, neglects maintenance on depreciating components – all things which slow the car down, there’s nothing monetary policy can do to fix those things. And here’s the point: it should not try to compensate.