Thursday, January 31, 2013

Are jobless recoveries the Fed's fault?



Matt O'Brien (who, in full disclosure, is the guy who recruited me to write for the Atlantic) hypothesizes that the "jobless recoveries" of recent decades have been caused by the Fed. Specifically, he thinks that the Fed has been practicing "opportunistic disinflation", allowing recessions to lower inflation, and then "stabilizing" inflation at a new, lower level after each recession by raising interest rates too soon. Here is the case:

Through the 1980s, postwar recessions happened when the Fed decided to raise rates to head off inflation, and recoveries happened when the Fed decided things had tamed down enough to lower rates. But now recessions happen when bubbles burst...and the Fed hasn't been able to cut interest rates enough to generate strong post-crash recoveries. Or maybe it hasn't wanted to... 
Why have interest rates and inflation mostly been falling for the past 30 years? In other words if the Fed has been de facto, and later de jure, targeting inflation for most of this period (and it has), why has inflation been on a down trend (and it has)?...  
CorePCEInflation2.png 
Say hello to "opportunistic disinflation...The Volcker Fed had come in for quite a bit of abuse when it whipped inflation at the expense of the severe 1981-82 downturn, and the Fed seems to have learned it was better not to leave its fingerprints on the business cycle.  
In other words, Let recessions do their dirty work for them. 
It's not hard for central bankers to get what they want without doing anything, as long as what they want is less inflation (and that's almost always what central bankers want). They just have to wait for a recession to come along ... and then keep waiting until inflation falls to where they want it. Then, once prices have declined enough for their taste, they cut rates (or buy bonds) to stabilize inflation at this new, lower level. But it's one thing to stabilize inflation at a lower level; it's another to keep it there. The Fed has to raise rates faster than it otherwise would during the subsequent recovery to keep inflation from going back to where it was before the recession. It's what the Fed calls "opportunistic disinflation," and it's hard to believe this wasn't their strategy looking at falling inflation the previous few decades. Not that we have to guess. Fed president Edward Boehene actually laid out this approach in 1989, and Fed governor Laurence Meyer endorsed the idea of "reducing inflation cycle-to-cycle" in a 1996 speech -- the same year the Wall Street Journal leaked an internal Fed memo outlining the policy.  
In short: Recoveries have been jobless, because that's how the Fed likes them.
I guess this is a pretty solid case. Fed memos and speeches, combined with the low path of observed inflation. However, I don't believe it.

Why not? Well, there have been three "jobless recoveries" in recent decades: the early-90s recovery, the early-2000s recovery, and the current recovery. Looking at Matt's inflation history graph, we see that in the 2000s, inflation didn't shift to a lower level - so, no "opportunistic disinflation" there (unless the Fed tried and failed!). In the current recovery, the Fed hit the Zero Lower Bound, and inflation actually fell below the Fed's desired rate. So let's look at the one remaining candidate for "opportunistic disinflation" - the early 90s. Here is a graph of the Federal Funds rate over time:



We see that the Fed cut rates during the early-90s recession, and kept cutting then for several years after that. Remember what Matt said: "The Fed has to raise rates faster than it otherwise would during the subsequent recovery to keep inflation from going back to where it was before the recession." According to this principle, the rate rise in 1995 1994 must have come earlier than it would have come, had the Greenspan Fed not been practicing "opportunistic disinflation."

But compared to other recessions, the 1994 rate rise came with a very long lag. In fact, the 1990s recession is nearly unique in that the Fed Funds kept falling for quite some time after GDP stopped contracting. In fact, by the time the Fed started raising rates in 1994, the unemployment rate had already fallen to around its pre-recession level:



In other words, it sure looks like the Fed didn't even start raising rates until after the unusually long "jobless recovery" of the early 1990s was already finished.

Now, of course, it is fashionable these days to say that looking at the Fed's policy rate actually tells us nothing whatsoever about monetary policy. If you believe that the Fed chooses the level of NGDP at all points in time, then by assumption, all "jobless recoveries" were chosen by the Fed, and the policy rate simply did what it had to do in order to produce the observed time path of NGDP.

But I am highly skeptical of this idea.

Actually, in the case of post-Volcker monetary policy, I find the typical story to be the most convincing one. Estimates of the Fed's "reaction function", such as this one by Clarida, Gali, and Gertler in 2000 and others since then, find that the Fed has always seemed to use a "Taylor-type" rule to set policy rates, but that the Fed's rule started putting more of an emphasis on inflation-fighting, and less on unemployment-fighting, since Volcker took over. According to this common received wisdom, the Volcker Recessions convinced America that the Fed wouldn't tolerate inflation, and then higher productivity growth in the 90s enabled Greenspan to keep rates low without causing inflation expectations to come un-anchored. That story would explain the lower inflation observed post-1980 in O'Brien's graph. But it's not the same thing as "opportunistic disinflation", and it would not lead to jobless recoveries, because the Fed would still set its policy rate to respond to the best current estimates of inflation and the output gap.

As for the Fed's memos and speeches suggesting opportunistic disinflation? Well, Fed memos and speeches suggest a lot of things. That doesn't mean that the Fed actually does them...

So while I also think the Fed has probably been a little too focused on inflation since the experience of the 70s, my gut tells me we need to look elsewhere for the source of the jobless recovery phenomenon. My own guess is that financial-based explanations, in particular the idea of "balance sheet recessions", is more compelling. As Matt noted, recessions with "jobless recoveries" (really, just recoveries with sluggish growth) have tended to follow very different kinds of financial events than pre-1990 recessions. Some international comparisons find that recoveries tend to be anemic after a certain kind of financial crisis. If I were a betting man, I'd put my money on that explanation.

16 comments:

  1. Getting Koo-ian lately? Although the post on Japan was conflicting in inspiration. :-)

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    1. I've always been Koo-ian.

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  2. The rate hikes started in 1994, not 1995.

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  3. Noah, have you read this?
    http://www.imf.org/external/pubs/ft/wp/2013/wp1310.pdf
    It seems that ther is no jobless but growth less recoveries

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  4. And here are two serious attempts to explain jobless recoveries.

    -The credit view (Calvo, Coricelli, Ottonello):
    http://www.columbia.edu/~gc2286/documents/JoblessandWagelessRecoveries-July252012.pdf

    -The structural view (Jaimovich, Siu):
    http://www.nber.org/papers/w18334.pdf

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  5. the Fed *was* pursuing opportunistic disinflation... but whether that causes jobless recoveries or not i doubt (maybe that's what you are saying but its not clear). But mainly that's because I doubt the whole jobless recovery thing in the first place.

    http://www.econbrowser.com/archives/2013/01/guest_contribut_31.html

    an ngdp growth targeting fed reaction function will look just like a taylor rule with equal weights on inflation on output - under the right conditions. So its hard to guess what the fed was doing until they actually told us that they favored a taylor rule with equal weights on the employment and inflation mandate.

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    1. I thought that Econbrowser post was spot on. Specifically:

      "Why have the last three recoveries been viewed as jobless, while previous recoveries were not? This is because the speed of recoveries has been slower than before. In the early 1990s and early 2000s, as well as after the Great Recession, slow growth meant that sizable output gaps persisted well into the recovery. In contrast, in most earlier recessions, the output trough was followed by a period of above-normal growth that pulled output back to its previous trend. As Okun’s Law predicts, unemployment also returned to normal, making the recoveries look job-full."

      Early on, at a Congressional Hearing a deferential Congresscritter tossed Bernanke a softball about Rogoff and Carmen's "This Time It's Different" and how recoveries are historically slow after financial crisis. Bernanke deadpanned that yes they're usually slow because of policy mistakes.

      This time the Fed hasn't received much help from fiscal policy, with government spending at austerity levels compared to past recoveries.

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  6. Anonymous2:45 PM

    Set aside the fact that we have had a ""little shock" in the aggregate global supply function in the form of a double amount of labor supply. That must have had some effect on prices and on taming inflation all over the world, specially in the former inflationist countries.
    What a convoluted and ad hoc theory for explaining a fact which can be explained in a very straight and clear manner, like the long term reduction in the thecnological rate of growth combined with the fact that recent booms were not caused at all by positive supply side shocks but by hot finantial and "artificial" debt-driven boosts.

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  7. Wonks Anonymous4:43 PM

    One thing the "opportunistic disinflation" story has going for it is that the Fed seems to have lowered its ceiling on what it considers to be an acceptable inflation rate. It was higher during the famously hawkish Volcker Fed.

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  8. The job market paper of Grace Weishi Gu, from Cornell (link from Cowen) suggests that the jobless recoveries are due to the increased fixed cost of providing employee benefits (which also vary cyclically). I think this makes a lot of intuitive sense, and she's obviously got some data to back it up.

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  9. It's quite possible that the Fed memos and speeches suggesting "opportunistic disinflation" were actually a reaction to, rather than evidence of a policy-related cause of, the jobless recoveries. Remember that HW Bush campaigned in 1992 using the argument that the 1990 recession was necessary to prevent inflation. It seems likely to me that Fed officials would have made similar arguments to shield themselves from criticism, when the reality is that they simply didn't have any more ideas on how to spur job creation, with or without inflation. Their statements should not be taken at face value.

    "it is fashionable these days to say that looking at the Fed's policy rate actually tells us nothing whatsoever about monetary policy"
    I think this point is under-appreciated. There are, in essence, two possible ways to lower nominal interest rates: one is by contracting the money supply to lower inflation rates, which is contractionary, and the other is to expand the money supply to provide liquidity, which is expansionary. And the Fed doesn't necessarily control which of these will happen when it chooses an interest rate target (strictly speaking it depends on time frame--what lowers nominal interest rates in the short run should raise them in the long run, and vice versa). While there is also money velocity to consider, which is slightly positively correlated with interest rates, I think that looking at monetary aggregates is fairly informative: http://research.stlouisfed.org/fredgraph.png?g=f7C

    After the 1990 recession, the money supply actually contracted, suggesting that the stance of monetary policy was relatively tight. Not so for 2001, which is consistent with the fact that inflation fell after 1990 and rose after 2001.

    In otherwords, there may have been opportunistic disinflation in 1990, but not so much in the other jobless recoveries.

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    1. But Bernanke was worried about deflation in 2002. The Reagan recovery had 4 percent inflation whereas all three subsequent recoveries had lower inflation and slower growth. Maybe this disinflation wasn't intentional or "opportunistic," but it happened.

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  10. Anonymous8:34 PM

    our three jobless recoveries coincide with our negative current account balances, since 1985/90

    http://research.stlouisfed.org/fred2/series/BOPBCAA?cid=125

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  11. Doc at the Radar Station11:06 PM

    "Some international comparisons find that recoveries tend to be anemic after a certain kind of financial crisis. If I were a betting man, I'd put my money on that explanation."

    I was curious about the early 90s sluggishness as well, and had completely forgotten about the S&L crisis...

    http://en.wikipedia.org/wiki/Resolution_Trust_Corporation

    Getting our financial system cleaned up should be priority one...

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    1. In the late 90s I believe Greenspan allowed unemployment to fall to 4 percent (without runaway inflation) not out of generousity of his Randian heart, but because the Fed was fighting international financial crises and panics.

      But to the main point, as O'Brien points out it's like the Fed switched from a long-term NGDP level trend of 5 percent to a target of 4 percent NGDP growth.

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