Wednesday, October 26, 2016

Yellen Has Many Questions

Ever since the FOMC’s last rate hike at the end of last year, Fed Chair Janet Yellen has sided with the committee’s doves who believe that there is no rush to hike again. They might have to settle for one rate hike before the end of the year. However, three of them (Yellen, FRB-NY President Bill Dudley, and FRB-Minneapolis President Neel Kashkari) recently have said that the economy has “room to run.” In effect, their new mantra is “Hysteresis”!

To my knowledge, Yellen used this word for the first time in a public presentation during her keynote speech at the 60th Economic Conference hosted by the FRB-Boston on October 14 and 15. The conference’s theme was “The Elusive ‘Great’ Recovery: Causes and Implications for Future Business Cycle Dynamics.” The word popped up four times in the text of Yellen’s remarks and two times in the footnotes and references. (Prior to that, it appeared only once, in a footnoted reference, in her speech at Jackson Hole titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.”)

The term as used by macroeconomists means that a severe downturn in demand during a recession could have a depressing impact on supply. If so, then “strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand,” according to Yellen.

While she did say that more research is needed, she also seems to like the concept since it dovetails with her dovish view that the economy has room to run. She devoted a paragraph in her speech to the possible positive effects of “temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market.” Here is what she said:
One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient--and, hence, more-productive--job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.
The title of all six papers presented during the conference ended with question marks. While Fed Chair Janet Yellen’s keynote address didn’t do the same, the text of her prepared remarks had 19 question marks related to her topic, which was “Macroeconomic Research After the Crisis.” Now without any further ado, here are the numerous questions Yellen asked economists to answer in her latest speech:

(1) “The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?

(2) “My second question asks whether individual differences within broad groups of actors in the economy can influence aggregate economic outcomes--in particular, what effect does such heterogeneity have on aggregate demand?

(3) “My third question concerns a key issue for monetary policy and macroeconomics that is less directly addressed by this conference: How does the financial sector interact with the broader economy?

(4) “What is the relationship between the buildup of excessive leverage and the value of real estate and other types of collateral, and what factors impede or facilitate the deleveraging process that follows?”

(5) “Does the economic fallout from a financial crisis depend on the particulars of the crisis, such as whether it involves widespread damage to household balance sheets?”

(6) “How does the nature and degree of the interconnections between financial firms affect the propagation and amplification of stress through the financial system and overall economy?”

(7) “[M]ost importantly--what can monetary policy and financial oversight do to reduce the frequency and severity of future crises?”

(8) “[I]s the persistent increase in the personal saving rate that we have observed since the collapse of the housing bubble primarily a result of a sustained shift toward more prudent underwriting standards by lenders? Is it something that will ultimately prove transitory once households finish repairing their balance sheets or become more confident about their future prospects for employment and income?”

(9) “My [next] question goes to the heart of monetary policy: What determines inflation?

(10) “Does the reduced sensitivity [of inflation to the labor market] reflect structural changes, such as globalization or a greater role for intangible capital in production that have reduced the importance of cyclical swings in domestic activity for firms’ marginal costs and pricing power? Or does it perhaps reflect the well-documented reluctance--or, alternatively, limited ability--of firms to cut the nominal wages of their employees, which could help to explain the relatively moderate movements in inflation we saw during and after the recession?”

(11) “Ultimately, both actual and expected inflation are tied to the central bank’s inflation target, whether that target is explicit or implicit. But how does this anchoring process occur? Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform? Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future? Or does the truth lie somewhere in between, with a change in expectations requiring some combination of clear communications about policymakers’ inflation goal, concrete policy actions to demonstrate their commitment to that goal, and at least some success in moving actual inflation toward its desired level in order to demonstrate the feasibility of the strategy?”

(12) “Do U.S. monetary policy actions affect advanced and emerging market countries differently? Do conventional and unconventional monetary policies spill over to other countries differently? And to what extent are U.S. interest rates and financial conditions influenced by easing measures abroad?”

Clearly, she had lots of questions. In her speech, Yellen inadvertently confirmed the sad state of macroeconomic “science” and raised some serious doubts about whether the FOMC understands the economy well enough to manage it with monetary policy. Yellen might have been asking the wrong crowd for answers to her questions. Everyone at the conference was a macroeconomist. She really needs to be asking micro-economists many of the questions pertaining to consumer and business behavior. Demographers might have some relevant thoughts. Focus groups representing Americans with all sorts of different backgrounds might provide more down-to-earth insights.

Maybe the world’s economy would work better and make more sense if there were fewer macroeconomists trying to manage it. Could it be that many of the problems that confound macroeconomists result from too many of them meddling with the economy as policymakers? That’s a question that no one asked at the conference, though one economist did suggest that doing less meddling should be considered as an option.

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