Recommended Reading from the Fed

There are two particularly good reads posted by Federal Reserve economists today. The first is "Deleveraging: Is it over and what was it?" by Claudia Sahm. The role of household deleveraging in the Great Recession has been heavily emphasized, notably at Atif Mian and Amir Sufi's very good new "House of Debt" blog. Sahm summarizes three new research papers on the topic of household deleveraging. The papers address three big questions:

1. When will deleveraging be over?
2. What do households do when they can't repay their debts?
3. Whose decision is deleveraging anyway?

The research on Question 2 is especially interesting:

"Given the increase in mortgage defaults in this recession, it took unusually long (averaging up to 3 years in some states) to go from initial delinquency to a completed foreclosure on a home. During the foreclosure process, households typically lived 'rent free' in their homes. So what did these households do with the extra cash? The authors find a significant improvement in the performance of credit card debt (reduced delinquency and lower balances). Although these households were under considerable financial stress and were already facing a huge hit to their credit scores due to a foreclosure, they used some of the freed up money to pay off their other debts...Normally economists think that if you give cash to households who are financially constrained they will spend it not use it to service debt."

Sahm's overall takeaway from the research she reviews is that:

"There was a big hit to 'permanent income' (households' expected lifetime income and net worth) and credit availability. Thus the level of spending and debt that made sense for households changed dramatically with the recession. Economists already understood this adjustment in the standard consumption framework even if the size and persistence of the shocks have been surprising. So in this sense "deleveraging" is simply a new way to frame the issue rather than a new behavior. And yet, we saw that the debt obligations that households made when everyone thought they were richer could not be easily undone."

Another Fed post worth reading today is a speech, "A Review of the Experience of Fielding the Survey of Consumer Expectations," by James McAndrews. The New York Fed's Survey of Consumer Expectations (SCE) is a relatively new monthly survey of consumers' inflation, labor market, and household finance expectations.

The effort that the NY Fed has devoted to developing this survey is testament to the increasing emphasis economists are placing on understanding the links between expectations and the economy. (This is near and dear to me, as a theme of my dissertation.) Expectations have long played a role in macroeconomic models, but are sometimes treated as an afterthought, probably because they can be difficult to observe and quantify. The SCE includes probabilistic survey questions, which ask respondents to describe their probability distribution over future outcomes. This reveals the uncertainty associated with consumers' expectations.

In the speech, McAndrews delves into some of the nitty-gritty of the multi-year survey development process, which is quite fascinating. He also summarizes the past research using the survey data.

Cab Drivers, Preachers, and Economists' Wives

Lately I have been working on a Great Depression-era economic history paper to constitute one chapter of my dissertation. The practice of writing a history paper is highly enjoyable. It can send you deep into the (thankfully in my case mostly digital) archives. For younger scholars, it is one of the best ways to learn about and reflect on your chosen profession. This can sometimes be quite humorous.

Irving Fisher was a Yale professor and one of the best-known economists of the early 20th century. His weekly Business Page, the closest thing to an economics blog of the time, was widely syndicated in newspapers across the country. His modern day counterpart greatly praises his debt deflation theory, and deservedly so. In addition to good insights, Fisher had many good lines.

The best came at a meeting of the American Academy of Political and Social Sciences in November 1933. Picture Fisher at the podium about to make the closing remarks for the meeting. He begins,

"It is more than fair of the presiding officer to give me not only the first word, but the last word."

(One of the other speakers was a United States Senator, by the way.) Maybe it doesn't take an economist to think this way, but it takes one to speak this way. This is just some relatively benign self-aggrandizement, and a good ego is always good for a good laugh. Another quote, from the 1971 Journal of Money, Credit, and Banking, also made me laugh, but seemed less benign.

"Who among us [economists] has not listened politely to the bizarre theories of the Great Depression as proffered by cab drivers, preachers, and (worst of all) economists' wives? One simply learns to avoid cabs, churches, and home each time the Grapes of Wrath makes one of the film festivals or books by Studs Terkel about Huey P. Long make the best-seller lists."

Fisher only asserts his superiority to other economists and politicians, whereas this economist asserts economists' intellectual superiority to the public at large, or at least its female and service professional components. "Isn't it cute when our wives try to understand the economy? Aren't we great for being so polite to the poor dolts?"

Now, the vast majority of economists I know today have the utmost respect for their spouses' intellects. What we should avoid at all costs is a "polite" disregard of the intellect of the general public. Economists shouldn't "avoid cabs, churches, and home." Cabs, churches and home are the economy. (And I can think of one particular preacher whose vision of economics will not be ignored.) Economic policy would function more smoothly if more people understood it. In a democracy, people deserve the chance to understand the economy and economic policies that affect their lives. This is put really well by Alan Blinder and coauthors (2009), regarding monetary policy:

"It may be time to pay some attention to communication with the general public...In the end, it is the general public that gives central banks their democratic legitimacy, and hence their independence."

This is also why I really respect efforts like those of Annamaria Lusardi to teach economic and financial literacy to the public under the assumption that everyone is capable of understanding, so long as they are given the opportunity to learn.

Long-Term Unemployment and the Dual Mandate

The Federal Reserve's mandate from Congress, as described in the Federal Reserve Act, is to promote "maximum employment, stable prices, and moderate long-term interest rates." In January 2012, the FOMC clarified that a PCE inflation rate of 2% was most consistent with the price stability part of the so-called "dual mandate." The FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy says:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

Lately, PCE inflation has been well below 2%. There is no similarly-specific definition of maximum employment, but I think it is safe to say that we are not there yet. So we seem to be in a situation in which the objectives are complementary--employment-boosting policies that also put some upward pressure on prices would get us closer to maximum employment and stable prices at the same time. This is supposed to be the "easy case" for monetary policymakers, earning the name "divine coincidence." The tougher case would come if inflation were to get up to or above 2% and employment were still too low. Then there would be a tradeoff between the employment and price stability objectives, making the Committee's balancing act more difficult.

San Francisco Federal President John Williams presents the case that the rise in the share of long-term unemployment should affect the approach that Committee members take when faced with such a balancing act. Williams and SF Fed Economist Glenn Rudebusch have a new working paper called "A Wedge in the Dual Mandate: Monetary Policy and Long-Term Unemployment." In this paper, they document key empirical facts about the share of long-term unemployment and explain how it alters the relationship between employment and inflation.

Source: Rudebusch and Williams 2014, p. 4.

First, the key empirical facts about long-term unemployment share in the U.S.:

1. It has trended upward over the past few decades.
2. It is countercyclical.
3. Its countercyclicality has increased in recent decades.

Fact 1 has been attributed to the aging population, women's rising labor force attachment, and increasing share of job losses that are permanent separations rather than temporary layoffs (Groshen and Potter 2003, Aaronson et al. 2010, Valletta 2011).

The long-term unemployed appear to place less downward pressure on wages and prices than the short-term unemployed. This may be because the long-term unemployed are less tied to the labor market and search less intensely for a job as they grow discouraged (e.g., Krueger and Mueller 2011). Stock (2011) and Gordon (2013) find that distinguishing between long- and short-term unemployment can help account for the puzzling lack of disinflation following the Great Recession. Rudebusch and Williams find a similar result by running Phillips Curve regressions that include short-term and long-term unemployment gaps as regressors. Only the coefficient on the short-term unemployment gap is negative and statistically significant, implying that short-run unemployment exerts downward pressure on prices while long-run unemployment does not.

The finding that long-term and short-term unemployment have different implications for price dynamics is very relevant for the Fed's pursuit of its dual mandate.  When the long-term unemployment share is high, this introduces a "wedge" between the employment and price stability portions of the mandate. Employment and inflation won't be as prone to moving in the same direction, because employment can get very low without much downward pressure on wages (and prices). To formalize what this means for monetary policy decisions, Rudebusch and Williams build a stylized model economy (skip ahead if not interested in the details) in which the central bank's objective is to minimize a quadratic loss function:
\begin{equation}
L=\tilde \pi + \lambda \tilde u,
\end{equation}
where pi tilde and u tilde are deviations of inflation from its target and unemployment from the natural rate, and lambda is the weight that policymakers place on unemployment stabilization versus inflation stabilization. Let the unemployment deviation depend on a demand shock v and the deviation of the short-term interest rate from the natural rate (IS equation):
\begin{equation}
\tilde u = \eta \tilde i + v
\end{equation}
 Let deviations in inflation depend on an inflation shock e and the deviation of the short-run unemployment rate s from its natural rate:
\begin{equation}
\tilde \pi = -\kappa \tilde s + e
\end{equation}
The short-run unemployment rate is a fraction of the overall unemployment rate u,
\begin{equation}
s=\theta u,
\end{equation} where
\begin{equation}
\theta=\bar \theta -\delta \tilde u + z,
\end{equation}
where z is a shock to the short-run unemployment share. If we substitute these equations into the loss function and take first order conditions, we arrive at an expression for the optimal deviation of inflation from its target:
\begin{equation}
\tilde \pi*=\frac{\lambda}{\lambda+\kappa^2 \theta^2}e-\frac{\lambda \kappa \bar u}{\lambda+\kappa^2 \theta^2}z
\end{equation}

The first thing to notice here is that the demand shock v does not show up in the optimal policy decision. This is the divine coincidence-- demand shocks impose no tradeoff between the employment and inflation objectives.

The second thing to notice is how the inflation shock e and the short-run unemployment share z. The first term is standard, and shows how the optimal policy partially offsets a positive (negative) inflation shock by raising (lowering) unemployment. The other term is new to this paper. A positive shock to theta acts like a negative inflation shock in the sense of prescribing a higher short-run unemployment rate and lower inflation rate. Another policy implication arises because theta affects the slope of the Phillips curve with respect to aggregate unemployment. This creates an asymmetry in the optimal policy response to inflation shocks that depends on theta.

During the Great Recession, the short-run unemployment share theta reached historic lows. Rudebusch and Williams simulate their model starting in the first quarter of 2014, using actual data from 2013 as initial conditions. They compare the optimal policy response implied by their model to that implied by a standard model (i.e. one that does not distinguish between short-run and long-run unemployment). The figure below displays the results. The quantitative results are not meant to be taken too seriously, since the models involve drastic oversimplifications, but the qualitative differences are  illustrative.The model that distinguishes between short-run and long-run unemployment (shown as black lines) prescribes a higher inflation rate--temporarily above 2%--than the standard model (shown as dashed red lines).

Source: Rudebusch and Williams 2014, p. 22

The authors conclude (emphasis added):

During the recent recession and recovery, the number of discouraged jobless excluded from the unemployment rate and the number of part-time employees wanting full-time work have reached historic highs. If the true measure of labor underutilization included these individuals, even though they have little or no eff ect on wage and price setting, then the wedge in the Fed's dual mandate would be even wider. Based on the analysis in this paper, the implications are clear: Optimal policy should trade off a transitory period of excessive inflation (beyond what is calculated using this paper's model) in order to bring the broader measure of underemployment to normal levels more quickly.

This is a very interesting and intuitive result, and is highly relevant to the policymaking environment in both the United States and elsewhere, particularly Europe. However, I'm not sure that the FOMC as a whole will take this paper's implications seriously. The committee does not share a single "loss function" like the quadratic function presented in the paper, which treats overshooting and undershooting of the inflation target symmetrically. Mark Thoma's comment on the paper is, "I'll believe the Fed will allow *intentional overshooting* of its inflation target when I see it."