The U.S. Federal Reserve faces a tough task in figuring out how best to respond to a highly unusual economic recovery. As chair Janet Yellen noted in a recent speech, it could use some help from academia.
So what key questions should researchers be trying to answer?
Let's start with what the Fed got right. Internal documents from 2009 and 2010 (now public) reveal that policy makers were largely aiming to return the unemployment rate to 5 percent by the end of 2015 (from nearly 10 percent at the end of 2010). The Fed’s staff expected that this would be associated with inflation rising slowly from near 1 percent to only about 1.5 percent by the end of 2015, before returning to the central bank's 2 percent target at some point thereafter. In terms of unemployment and inflation, the Fed basically got the recovery it wanted: The unemployment rate has been close to 5 percent for the past year, and the Fed’s preferred measure of inflationary pressures is at 1.7 percent.
The Fed was surprised by two aspects of the recovery. The first is that it provided, and continues to provide, a lot more monetary stimulus -- in the form of low interest rates and asset purchases -- than it expected back in 2010. As Fed vice-chair Stan Fischer described in a recent speech, economists have yet to understand why, but that mystery hasn’t prevented the central bank from achieving its desired unemployment and inflation objectives.
The second surprise is much more troubling: Growth over the past six or seven years has been much slower than the Fed expected. It’s important to emphasize that the slow growth doesn’t mean that monetary policy hasn't worked: Like I said, the Fed has met its inflation and unemployment objectives. What's strange is that success in achieving those goals has been associated with such slow growth.
I’ve heard (at least) three explanations. One, preferred by most academics, is that demographic and technological changes -- which started before the 2008 financial crisis -- took the Fed by surprise. Another possibility, highlighted in Yellen's speech, is that the recovery engineered by the Fed was so slow that it did (possibly reversible) damage to the supply side -- for example, as long-term unemployment eroded the skills and motivation of workers. A third, popular among financial market participants, is that the Fed’s easy-money policies have stunted growth by encouraging people to make bad investments.
I lean toward the second explanation. But I feel much more confident in saying that solving the growth conundrum should be a priority for researchers. In deciding what to do about a decidedly lackluster economy, the Fed needs the best evidence and thinking that it can get.
Narayana Kocherlakota is the Lionel W. McKenzie professor of economics at the University of Rochester. He served as president of the Federal Reserve Bank of Minneapolis from 2009 through 2015.
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