Trading in Your Feathers
There are two main dovish arguments. The first is that we're "nowhere close" to full employment or meaningful capacity constraints, as the Economic Policy Institute's Josh Bivens argues. The second is that, even if we are close, it's worth chancing it with inflation because the benefits of a robust recovery greatly exceed its risks of taking it a bit too far, as The Economist's Ryan Avent and The Financial Times' Cardiff Garcia both have said.
Bivens argues that the U.S. economy hasn't recovered in a significant way. He suggests the output gap has shrank by less than half, or perhaps even less than a third. It's the thoroughest update I've seen on the dovish case. What it boils down to is that the output gap looks big and employment is still depressed, and there's no evidence of price inflation or fiscal crowding-out.
Where do Bivens and I diverge? We definitely do. The key part about most definitions of full employment is the behavior of wages. You know you're at full employment when you see wages increasing in a big way. You know you're not when wage growth is quiet. This is why I am watching the wage determination process and at quits. There's really no way to get to that definition of full employment from estimates of the output or unemployment gaps, as that assumes the level of potential, the essence of what you're trying to prove. Inflation comes closer, but it will likely lag wages.
What I'd love to hear him answer: The U.S. is seeing 8 million too many quits a year for there to have been no reduction in slack in labor markets. That's 6 percent of total employment. In fact, quits suggest the unemployment rate is accurately measuring labor-market slack.
Avent's and Garcia's arguments are more interesting, and we agree much more than we disagree. Both are willing to accept that the output gap isn't quite as large as Bivens suggests. Yet Avent and Garcia both say it's worth pressing onward because we might be able to recoup lost capacity, give wages a boost after a long period of stagnation, and because a macroeconomic equilibrium with slightly higher inflation and higher nominal interest rates is in itself desirable. The last point is that when inflation and interest rates are too low, it renders monetary policy impotent as a tool to fight future recessions.
Right. There's no doubt that the costs and benefits of an "overshoot" of full employment are asymmetric. Stay too loose for too long, and you get a temporary bit of inflation. Exit too early, and you leave the work of fixing the recession unfinished forever. Who wouldn't take the first one?
The problem with this cost-benefit logic is that the consensus policy track already agrees with it, as do I, to the extent to which the logic works. Futures markets anticipate the first rate hike in the fall of 2015. Rate are then set to rise about one percentage point per year. This locks in a solid amount of "overshoot" already.
How do I figure that? The unemployment rate is 6.7 percent. It has fallen roughly 0.8 percentage points per year. Extrapolate forward to the fall of 2015, and you get that the first rate hike will happen with an unemployment rate of about 5.5 percent. The Fed's estimate of the natural rate of unemployment is 5.2 percent to 5.8 percent, and the middle of that range is 5.5 percent.
Markets therefore expect the Fed to cross its own estimate of full employment with its policy rate at zero. That's extraordinary. See the graph below. By the time the hikes actually kick in -- 2016 and 2017 -- unemployment could be the four-percent range. It's hard to see how that exit wouldn't produce an overshoot and a jump in wages, and how that wouldn't be sufficient to get interest rates way off the zero lower bound.
Jared Bernstein and Dean Baker, who also wrote in response to my piece in Bloomberg, say that quits aren't that high, and that 6.7 percent unemployment is still way above full employment. What the graph above shows is that this is really a matter of degree. 6.7 percent is above full employment, yes, but full employment is two years away.
Their implication is that a yet larger overshoot is desirable. Much of their arguments are abstract, but the specifics make it almost unbelievable: Should the first rate hike really come when unemployment has a four in the first digit? I'm all with them until that point.
I think the expected path for monetary policy is already dovish, and wisely so. It was an awful recession. But there really is such a thing as "too much." This is already quite a lot. And to say that the current policy path is broadly appropriate, as I've done, really does imply that it's time to start talking about how tight the labor market is, about how much slack the U.S. economy has left, and about tightening.
The reason the Fed is tapering now and talking ever more frankly about rate hikes is ultimately because yes, it's about time.
Updates (3/13 wrote post, 3/14 added chart)
Baker suggests that unemployment will fall 0.3 percent a year for the next three years, given GDP growth and productivity forecasts. I think that's unrealistically low. It's quite likely that labor-force dropouts continue to elevate that rate above what we might expect from GDP and productivity. In the case that he's right, though, and we wake up in mid-2015 with the unemployment rate still in the mid-6-percent range, I wouldn't object to his policy prescription. Nor would, I think, the Fed. No need for tightening then.
As Avent points out, the Fed's forecast is that progress on unemployment will slow down, though not to 0.3 percent per year. Last December, they saw unemployment between 5.8 percent and 6.1 percent by the end of 2015. I think it's likely this forecast is revised lower next week; the unemployment rate has dropped 0.3 percentage points since then.
But even if you don't, my basic point wasn't super sensitive to small differences in the unemployment rate. 5.8-percent unemployment still means the first rate hike comes as the Fed hits its own threshold for full employment. Hikes that proceed at one percentage point per year still mean that, at the end of 2016, the Fed will have its policy rate at one percent while unemployment is in the low-5-percent range.
When you compare that to Fed exits from the 1990 and 2001 recessions, it is clear that this is already a departure from the norm, and to the dovish side. And rightly so. This is not 1990 or 2001. Yet waiting until 2016 or 2017, as Brad DeLong suggested in his excellent overview of the debate, would also seem imprudent, as I've argued above.
Avent argues that none of this is overshooting unless inflation rises, and markets don't expect higher inflation, judging from breakevens. I think this is the right argument. Perhaps it is that markets think the Fed can get away with the moderate overshoot it has planned -- overshoot in terms of real potential -- without much of a rise in inflation.