Is Fed Chairman Ben Bernanke the Don Quixote of monetary policy?
Comments he made in Jackson Hole this past August about unemployment at first blush seem to suggest so.
With little notice, Bernanke seemed to buck conventional wisdom and suggest that the Fed can—and indeed should—try to influence the long-run unemployment rate.
A little background: Even though the Fed's dual mandate is low unemployment and low inflation, most monetary policy experts think the central bank can only control the inflation rate through its interest rate policy.
Drawing on Milton Friedman's work, central bankers generally don't believe they can control the economy’s natural rate of unemployment. Monetary policy can help the economy get back to that natural rate, but it can't target what the rate is. That’s the province of regulatory and tax policy as well as the growth rates of productivity and innovation.
But in remarks that were mostly overlooked in Jackson Hole, here's what Bernanke said:
“Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well.”
“Longer-term objectives?” Is the Chairman hinting that maybe the Fed can target the long-term unemployment rate?
In fact, he is. And that's key to understanding why he likely believes easy monetary policy is the best prescription for the economy—and why it could remain easy as long as long-term unemployment remains high.
Here’s the concern: In general, when recessions are short-lived, as they have mostly been in the post-World War II era, the economy returns to its natural unemployment rate with a little nudging from the Fed. Not much is lost by the workforce in the way of jobs skills and experience.
But long recessions and large numbers of long-term unemployed erode the quality of the workforce. As we learned Friday, the number of Americans unemployed for 27 weeks or longer rose by 2 million to 6.2 million.
As these long-term unemployed lose contact with the jobs market, their skills erode. They become out of sync with the demands of employers and skill-shortages set in. Ultimately, the nation’s natural, or long-term, unemployment rate can ratchet higher.
Economists point to the failure of unemployment rates in Italy and the U.K. to fall back to their prior level during the 1980s. Italy's unemployment, normally below six percent, surged past 10 percent and remained there for a decade. In the U.S., by contrast, unemployment peaked in 1983 but gradually declined to around five percent by 1989.
Why the difference? Economists such as Laurence Ball at Johns Hopkins see a force called hysteresis at work. Hysteresis is when a shock to a system pushes something down and it doesn’t spring back. The differences in monetary policy probably explain why employment didn't bounce back in the U.K. and Italy but did in the US.
During the 1980s recession, Italy and the U.K. both hiked rates (for different reasons). Fed Chairman Paul Volcker, by contrast, abandoned his inflation-fighting rate hikes and eased.
With interest rates at zero, Bernanke can’t ease any more. That’s why he’s looking for alternate ways to influence the economy and the unemployment rate through such means as quantitative easing and now "Operation Twist."
His fear is that if he does not do as much as he can right now, the U.S. could not just be in for an extended period of high unemployment, but that the long-term rate will go higher.
Listen to what he said in Jackson Hole: “In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.”
This actually complicates the Fed’s communications strategy, a key tool it could use to ease conditions.
In general, most Fed officials think they cannot target the unemployment rate. There is no reason to think that Bernanke disagrees with this. But in this particular instance, there is support in the academic world for doing just that—and Bernanke is making the case.
At the same time, the Fed is considering changing its communications strategy to assure markets that interest rates can remain low as long as unemployment is at a certain level. This has the benefit of letting the market make adjustments for Fed policy when employment data comes in. For example, if the unemployment rate is trending higher than the Fed’s target, markets would bid down yields, easing conditions (and vice versa.)
That’s all well and good as far as the market is concerned. But the fear is that the Fed's actions could be misinterpreted by the public—and especially politicians.
If the Fed ties monetary policy to a particular unemployment rate during this extraordinary time, what is to stop politicians from demanding the Fed keep policy easy until an even lower level is achieved?
The public also will get the wrong idea that the Fed can always target the long-term unemployment rate, when, in fact, Bernanke is suggesting this is a special case.
The Fed will be debating these ideas at its November meeting. But there is a lot of concern within the central bank that tying policy to a particular unemployment rate—while a potentially effective tool—carries too much risk.
So, the Fed will likely be quietly aiming to bring down the unemployment rate—and especially the number of long-term unemployed. But it’s a long-shot to think it’ll be explicit about it.