Ryan Avent laments the failure of government and Ben Bernanke forgetting what he knew about the Great Depression. Tim Duy reads the Bernanke of 2003 and is even more depressed. Having spent a day rereading some New Keynesian classics, I’m starting to get surprised by people being surprised. So much energy over the past 30 years has been put on the idea that the central bank needs to be structurally conservative and always prioritize inflation-fighting. As friend of the blog Andrew Bossie recently wrote, “Isn’t Ben Bernanke what the New Keynesians want?”
At this point there’s a pretty substantial critique of “Dark Ages” macroeconomics. But there’s another critique that bubbles up from time to time among lefty economics bloggers and that’s how the New Keynesians, or those who would carry the light in the dark times, essentially left themselves unprepared to deal with a Great Depression-style event.
Take Kenneth Rogoff. Rogoff is wondering why the Federal Reserve is too conservative and won’t tolerate going over the inflation target to help with the recovery and is trying to convince people otherwise. But one of the first times I had encountered Rogoff’s work back as a graduate student was his classic 1985 paper that opens with the all-you-need-to-know statement: “Society can sometimes make itself better off by appointing a central banker who does not share the social objective function, but instead places ‘too large’ a weight on inflation-rate stabilization relative to employment stabilization.” Sounds like right now, doesn’t it?
That individuals, institutional structures, rewards and the zones of acceptable discussion and policy would all focus on finding ways to emphasize inflation-fighting at the expense of employment and output is a key feature of the New Keynesian literature, from works like that through the big summaries and statements like 1999’s The Science of Monetary Policy: A New Keynesian Perspective. This isn’t the dark ages economics. Even for those who were trying to carry the light in dark economic theory times, a lot of energy was spent trying to figure out how to condition a central banker to be like a fire chief who hesitates in using the hose to put out a fire raging in an orphanage, lest some of the children drown.
I got to thinking about the 1985 paper as a result of Chicago Federal Reserve President Charles Evan’s speech The Fed’s Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy (the speech really is that good, read it!). Krugman quoted the following from the speech: “Imagine that inflation was running at 5 percent against our inflation objective of 2 percent. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.”
It is important to understand what that means. It isn’t just shorthand or a guess, there’s a series of equations with values and assumptions in them that we should unpack. Look at this equation from the Science paper, which is a statement of the goal of a central bank:
Evans uses a version of this equation in his paper. Let’s rewrite that slightly more in line with how Evans uses it and then translate it to a general audience:
The Federal Reserve wants to balance between its inflation target and stabilizing output. Rogoff argued that, since we need a conservative, hawkish Federal Reserve, the λ variable needs to be added as a balance between the two goals. It should be less than one, because as a result of an asymmetry of the two goals we need a Federal Reserve chairman who is more worried about inflation than output.
Evan then notes that it is “reasonably conservative to set λ equal to ¼” and that “Okun’s Law…says that a 1 percentage point gap between actual and potential output corresponds to a one half percentage point gap between unemployment and its natural rate.” Turning from output to employment – remember the Fed’s mandate is employment – gives us a four on the outside (2 squared).
As Evans notes, since a conservative sets λ equal to ¼, and since 4*(1/4) is one, “we see that the conservative central banker attempts to minimize the equally weighted sum of squared inflation and unemployment deviations.”
So putting in some numbers, a 9% unemployment rate with a very high natural unemployment rate of 6% plus inflation checked is a loss of 9 ([2-2]^2 + [9-6]^2). A 5% inflation rate with unemployment checked is a loss of 9 as well ([5-2]^2+[6-6]^2).
So when people say that our employment situation is as bad as if inflation was running at 5% they are looking at it from the point of view of a very conservative central banker who cares less about employment than inflation. If you see the situation as I do, with a u* near 5 and a u near 10, as well as an actual need to penalize the central banker for bringing in too low inflation, then the score is even higher.
So what gives? We can understand the FOMC dissenters in line with this equation. If the Federal Reserve is even more conservative than a 0.25 value for λ, say if their value was arbitrarily near zero, then we can understand how they only care about inflation. Another is that if you believe that the “natural rate” of unemployment, u*, is 9%, then there’s no problem to solve. There’s evidence that the Fed dissenters believe these thoughts. Another problem is if you see coming in under the inflation target as an opportunity to lock in disinflation rather than a problem for employment that you have an obligation to solve, then this equation doesn’t even make sense. Here’s what locking in disinflation while U.S. wages stagnate looks like:
The fact that we have a dual mandate for the Federal Reserve isn’t a trivial matter. And surveying the discourse amidst the Lesser Depression in this way calls even more forcefully for something like the Evans rule: the Federal Reserve should simply agree to keep interest rates at zero and tolerate 3 percent average inflation until unemployment is down to 7 percent.