Yellen's Storyline Strategy

Storyline, launched this week at the Washington Post, is "dedicated to the power of stories to help us understand complicated, critical things." Storyline will be a sister site to Wonkblog, and will mix storytelling and data journalism. The editor, Jim Tankersley, introduces the new site:

"We’re focused on public policy, but not on Washington process. We care about policy as experienced by people across America. About the problems in people’s lives that demand a shift from government policymakers and about the way policies from Washington are shifting how people live. 

We’ll tell those stories at Web speed and frequency. 

We’ll ground them in data — insights from empirical research and our own deep-dive analysis — to add big-picture context to tightly focused human drama."

I couldn't help but be reminded of Janet Yellen's first public speech as Fed chair on March 31. She took the approach Tankersley is aiming for. She began with the data:

"Since the unemployment rate peaked at 10 percent in October 2009, the economy has added more than 7-1/2 million jobs and the unemployment rate has fallen more than 3 percentage points to 6.7 percent. That progress has been gradual but remarkably steady--February was the 41st consecutive month of payroll growth, one of the longest stretches ever....But while there has been steady progress, there is also no doubt that the economy and the job market are not back to normal health. That will not be news to many of you, or to the 348,000 people in and around Chicago who were counted as looking for work in January...The recovery still feels like a recession to many Americans, and it also looks that way in some economic statistics. At 6.7 percent, the national unemployment rate is still higher than it ever got during the 2001 recession... Research shows employers are less willing to hire the long-term unemployed and often prefer other job candidates with less or even no relevant experience."

Then she added three stories:

"That is what Dorine Poole learned, after she lost her job processing medical insurance claims, just as the recession was getting started. Like many others, she could not find any job, despite clerical skills and experience acquired over 15 years of steady employment. When employers started hiring again, two years of unemployment became a disqualification. Even those needing her skills and experience preferred less qualified workers without a long spell of unemployment. That career, that part of Dorine's life, had ended. 

For Dorine and others, we know that workers displaced by layoffs and plant closures who manage to find work suffer long-lasting and often permanent wage reductions. Jermaine Brownlee was an apprentice plumber and skilled construction worker when the recession hit, and he saw his wages drop sharply as he scrambled for odd jobs and temporary work. He is doing better now, but still working for a lower wage than he earned before the recession. 

Vicki Lira lost her full-time job of 20 years when the printing plant she worked in shut down in 2006. Then she lost a job processing mortgage applications when the housing market crashed. Vicki faced some very difficult years. At times she was homeless. Today she enjoys her part-time job serving food samples to customers at a grocery store but wishes she could get more hours."

The inclusion of these anecdotes was unusual enough for a monetary policy speech that Yellen felt obligated to explain herself, in what could be a perfect advertisement for Storyline.

"I have described the experiences of Dorine, Jermaine, and Vicki because they tell us important things that the unemployment rate alone cannot. First, they are a reminder that there are real people behind the statistics, struggling to get by and eager for the opportunity to build better lives. Second, their experiences show some of the uniquely challenging and lasting effects of the Great Recession. Recognizing and trying to understand these effects helps provide a clearer picture of the progress we have made in the recovery, as well as a view of just how far we still have to go."

Recognition of the power of story is not new to the Federal Reserve. I noted in a January 2013 post that the word "story" appears 82 times in 2007 FOMC transcripts. One member, Frederic Mishkin, said that "We need to tell a story, a good narrative, about [the forecasts]. To be understood, the forecasts need a story behind them. I strongly believe that we need to write up a good story and that a good narrative can help us obtain public support for our policy actions—which is, again, a critical factor."

But Yellen's emphasis on personal stories as a communication device does seem new. I think it is no coincidence that her husband, George Akerlof, is the author (with Rachel Kranton) of Identity Economics, which "introduces identity—a person’s sense of self—into economic analysis." Yellen's stories of Dorine, Jermaine, and Vicki are stories of identity, conveying the idea that a legitimate cost of a poor labor market is an identity cost. 

The Most Transparent Central Bank in the World?

At a hearing before the House Financial Services Committee on Wednesday, Federal Reserve Chair Janet Yellen called the Fed the "the most transparent central bank to my knowledge in the world.” I'll try to evaluate her claim in this post. For context, the hearing focused on legislation proposed by House Republicans called the Federal Reserve Accountability and Transparency Act, which would require the Fed to choose and disclose a rule for making policy decisions. Alan Blinder explains:

"A 'rule' in this context means a precise set of instructions—often a mathematical formula—that tells the Fed how to set monetary policy. Strictly speaking, with such a rule in place, you don't need a committee to make decisions—or even a human being. A handheld calculator will do."

Blinder, who has long advocated central bank transparency, calls FRAT an "unneccessary fix" for the Fed. Discretion by an independent Fed needs not impede or preclude transparency, and the imposition of rules-based policy would not guarantee improved accountability and transparency.

What about Yellen's description of the Fed as the most transparent central bank in the world? Is it reasonable?  Nergiz Dincer and Barry Eichengreen have constructed an index of transparency for more than 100 central banks. Updates to the index, released earlier this year, cover the years 1998 to 2010.

Dincer and Eichengreen rate transparency on a scale of 0 (lowest) to 15 (highest). The 15-point transparency scale is based on awarding up to 3 points in each of the following components:

1. Political transparency: statement of objectives and prioritization, quantification of primary objective, and explicit contracts between monetary authority and government
2. Economic transparency: publication of central bank data, models, and forecasts
3. Procedural transparency: use of an explicit policy rule or strategy, and transparency over the decision-making process and deliberations
4. Policy transparency: prompt announcement and explanations of decisions and intentions; 
5. Operational transparency: regular evaluation of the extent to which targets have been achieved, provision of information on disturbances that affect monetary policy transmission, and evaluation of policy outcomes

The most transparent central banks as of 2010 are the Swedish Riksbank (14.5), the Reserve Bank of New Zealand (14), the Central Bank of Hungary (13.5), the Czech National Bank (12), the Bank of England (12), and the Bank of Israel (11.5).

The Federal Reserve, with a transparency score of 11, is tied for 7th with the ECB, the Bank of Canada, and the Reserve Bank of Australia. In 1998, the Fed's score was 8.5, and has held steady at 11 since 2006. So it is certainly reasonable to say that the Fed is among the most transparent central banks in the world. And since we can interpret transparency subjectively, and any rating scale has some degree of arbitrariness, these ratings don't disprove Yellen's claim.

The ratings were made in 2010. The Fed earned 1 out of 3 points in the political transparency category, 2.5 of 3 in procedural transparency, 1.5 of 3 in operational transparency, and perfect scores in the other categories.  The Fed's score should improve at the next update, since the January 2012 announcement of a quantitative 2% inflation goal may restore some partial credit in the political transparency category. A perfect 15 is not necessarily desirable. For example, one point in the political transparency category can only be awarded if the bank has either a single explicit objective or explicitly ranks its objectives in order or priority. Most banks that earn that point explicitly target inflation. To earn that point, the Fed would have to formally declare its price stability mandate a higher priority than its maximum employment mandate (or vice versa, which seems highly unlikely), while the Congressional mandate in the Federal Reserve Act does not prioritize one over the other.

Thoughts on the Fed's New Labor Market Conditions Index

I'm usually one to get excited about new data series and economic indicators. I am really excited, for example, about the Fed's new Survey of Consumer Expectations, and have already incorporated it into my own research. However, reading about the Fed's new Labor Market Conditions Index (LMCI), which made its debut in the July 15 Monetary Policy Report, I was slightly underwhelmed, and I'll try to explain why.

David Wessel introduces the index as follows:

Once upon a time, when the Federal Reserve talked about the labor market, it was almost always talking about the unemployment rate or the change in the number of jobs. But the world has grown more complicated, and Fed Chairwoman Janet Yellen has pointed to a host of other labor-market measures. 

But these different indicators often point in different directions, which can make it hard to tell if the labor market is getting better or getting worse. So four Fed staff economists have come to the rescue with a new “labor markets conditions index” that uses a statistical model to summarize monthly changes in 19 labor-market into a single handy gauge.

The Fed economists employ a widely-used statistical model called a dynamic factor model. As they describe:

A factor model is a statistical tool intended to extract a small number of unobserved factors that summarize the comovement among a larger set of correlated time series. In our model, these factors are assumed to summarize overall labor market conditions. What we call the LMCI is the primary source of common variation among 19 labor market indicators. One essential feature of our factor model is that its inference about labor market conditions places greater weight on indicators whose movements are highly correlated with each other. And, when indicators provide disparate signals, the model's assessment of overall labor market conditions reflects primarily those indicators that are in broad agreement.

The 19 labor market indicators that are summarized by the LMCI include measures of unemployment, underemployment, employment, weekly work hours, wages, vacancies, hiring, layoffs, quits, and sentiment in consumer and business surveys. The data is monthly and seasonally adjusted, and the index begins in 1976.

A minor quibble with the index is its inclusion of wages in the list of indicators. This introduces endogeneity that makes it unsuitable for use in Phillips Curve-type estimations of the relationship between labor market conditions and wages or inflation. In other words, we can't attempt to estimate how wages depend on labor market tightness if our measure of labor market tightness already depends on wages by construction.

The main reason I'm not too excited about the LMCI is that its correlation coefficient with the unemployment rate is -0.96. They are almost perfectly negatively correlated--and when you consider measurement error you can't even reject that they are perfectly negatively correlated-- so the LMCI doesn't tell you anything that the unemployment rate wouldn't already tell you. Given the choice, I'd rather just use the unemployment rate since it is simpler, intuitive, and already widely-used.

In the Monetary Policy Report, it is hard to see the value added by the LMCI. The report shows a graph of the three-month moving average of the change in LMCI since 2002 (below). Values above zero are interpreted as an improving labor market and below zero a deteriorating labor market. Below the graph, I placed a graph of the change in the unemployment rate since 2002. They are qualitatively the same. When unemployment is rising, the index indicates that labor market conditions are deteriorating, and when unemployment is falling, the index indicates that labor market conditions are improving.

The index takes 19 indicators that tell us different things about the labor market and distills the information down to one indicator based on common movements in the indicators. What they have in common happens to be summarized by the unemployment rate. That is perfectly fine. If we need a single summary statistic of the labor market, we can use the unemployment rate or the LMCI.

The thing is that we don't really need or even want a single summary statistic of the labor market to be used for policymaking. The Fed does not practice rule-based monetary policy that requires it to make policy decisions based on a small number of measures. A benefit of discretionary policy is that policymakers can look at what many different indicators are telling them. As Wessel wrote, "the world has grown more complicated, and Fed Chairwoman Janet Yellen has pointed to a host of other labor-market measures." Yellen noted, for example, that the median duration of unemployment and proportion of workers employed part time because they are unable to find full-time work remain above their long-run average. This tells us something different than what the unemployment rate tells us, but that's OK; the FOMC has the discretion to take multiple considerations into account.

The construction of the LMCI is a nice statistical exercise, and the fact that it is so highly correlated with the unemployment rate is an interesting result that would be worth investigating further; maybe this will be discussed in the forthcoming FEDS working paper that will describe the LMCI in more detail. I just want to stress the Fed economists' wise point that "A single model is...no substitute for judicious consideration of the various indicators," and recommend that policymakers and journalists not neglect the valuable information contained in various labor market indicators now that we have a "single handy gauge."

Economic Inclusion and the Global Common Good

On July 11 and 12, Pope Francis met with a group of policymakers, economists, and other influential thinkers at a conference called “The Global Common Good: Towards a More Inclusive Economy.” The conference was sponsored by the Pontifical Council for Justice and Peace and held at the Pontifical Academy of Science in Vatican City.

Pope Francis spoke out against "anthropological reductionism" in the economy, echoing a tradition of Catholic social teaching that links economic inclusion to human dignity. The 1986 pastoral letter Economic Justice for All says:

"Every economic decision and institution must be judged in light of whether it protects or undermines the dignity of the human person...We judge any economic system by what it does for and to people and by how it permits all to participate in it. The economy should serve people, not the other way around... 

All people have a right to participate in the economic life of society. Basic justice demands that people be assured a minimum level of participation in the economy. It is wrong for a person or group to be excluded unfairly or to be unable to participate or contribute to the economy. For example, people who are both able and willing, but cannot get a job are deprived of the participation that is so vital to human development. For, it is through employment that most individuals and families meet their material needs, exercise their talents, and have an opportunity to contribute to the larger community. Such participation has special significance in our tradition because we believe that it is a means by which we join in carrying forward God's creative activity."

One participant at the conference was Muhammad Yunus, a pioneer of microcredit and microfinance and the founder of Grameen Bank in Bangladesh. Grameen Bank is called the bank of the poor because its borrowers, mostly poor and female, own 95% of the bank's equity. Yunus and the Grameen Bank jointly won the Nobel Peace Prize in 2006. Yunus has a PhD in economics from Vanderbilt and is the author of Banker to the Poor and Creating a World Without Poverty. At the conference, Yunus spoke about social business and about sharing and caring as basic human qualities.

Development economist Jeffrey Sachs also attended the conference. Sachs, author of The End of Poverty, founded the ambitious and controversial Millennium Villages Project. For a glimpse into the project from two different perspectives, I recommend Russ Roberts' interviews with Sachs and Nina Munk on the EconTalk podcast. 

Mark Carney, Governor of the Bank of England, attended the conference as well. Carney has spoken previously about economic inclusion. He gave a speech at the Conference on Inclusive Capitalism in London this May, in which he remarked:

"To maintain the balance of an inclusive social contract, it is necessary to recognise the importance of values and beliefs in economic life. Economic and political philosophers from Adam Smith (1759) to Hayek (1960) have long recognised that beliefs are part of inherited social capital, which provides the social framework for the free market. Social capital refers to the links, shared values and beliefs in a society which encourage individuals not only to take responsibility for themselves and their families but also to trust each other and work collaboratively to support each other.

So what values and beliefs are the foundations of inclusive capitalism? Clearly to succeed in the global economy, dynamism is essential. To align incentives across generations, a long-term perspective is required. For markets to sustain their legitimacy, they need to be not only effective but also fair. Nowhere is that need more acute than in financial markets; finance has to be trusted. And to value others demands engaged citizens who recognise their obligations to each other. In short, there needs to be a sense of society."

Also in attendance were Jose Angel Gurria, Secretary General of the OECD; Michel Camdessus, former managing director of International Monetary Fund; Ngozi Okonjo-Iweala, Finance Minister of Nigeria; Donald Kaberuka, President of the African Development Bank; and Huguette Labelle of Transparency International. A complete list of attendants and more detailed remarks from the conference should be up at the Pontifical Council for Justice and Peace website in the next few days.  I look forward to seeing what kinds of practical proposals might have been discussed.

The Unemployment Cost of Below-Target Inflation

Recently, inflation in the United States has been consistently below its 2% target. The situation in Sweden is similar, but has lasted much longer. The Swedish Riksbank announced a 2% CPI inflation target in 1993, to apply beginning in 1995. By 1997, the target was credible in the sense that inflation expectations were consistently in line with the target. From 1997 to 2011, however, CPI inflation only averaged 1.4%. In a forthcoming paper in the AEJ: Macroeconomics, Lars Svensson uses the Swedish case to estimate the possible unemployment cost of inflation below a credible target.

Svensson notes that inflation expectations that are statistically and economically higher than inflation for many years do not pass standard tests of rationality. He builds upon the "near-rational" expectations framework of Akerlof, Dickens, and Perry (2000). In Akerlof et al.'s model, when inflation is fairly close to zero, a fraction of people simply neglect inflation, and behave as if inflation were zero. This is not too unreasonable--it saves them the computational trouble of thinking about inflation and isn't too costly if inflation is really low. Thus, at low rates of inflation, prices and wages are consistently lower relative to nominal aggregate demand than they would be at zero inflation, permitting sustained higher output and employment. At higher levels of inflation, fewer people neglect it. This gives the Phillips Curve has a "hump shape"; unemployment is non-monotonic in inflation but is minimized at some low level of inflation.

In the case of Sweden, the near-rational model is modified because people are not behaving as if inflation were zero, but rather as if it were 2%, when in fact it is lower than 2%. Instead of permitting higher output and employment, the reverse happens. The figure below shows Svensson's interpretation of the Swedish economy's location on its hypothetical modified long-run Phillips curve. The encircled section is where Sweden has been for over a decade, with inflation mostly below 2% and unemployment high. If inflation were to increase above 2%, unemployment would actually decline, because people would still behave as if it were 2%. But there is a limit. If inflation gets too high (beyond about 4% in the figure), people no longer behave as if inflation were 2%, and the inflation-unemployment tradeoff changes sign.

Source: Svensson 2014

As Svensson explains,

"Suppose that nominal wages are set in negotiations a year in advance to achieve a particular target real wage next year at the price level expected for that year. If the inflation expectations equal the inflation target, the price level expected for next year is the current price level increased by the inflation target. This together with the target real wage then determines the level of nominal wages set for next year. If actual inflation over the coming year then falls short of the inflation target, the price level next year will be lower than anticipated, and the real wage will be higher than the target real wage. This will lead to lower employment and higher unemployment."

Svensson presents narrative evidence that central wage negotiations in Sweden are indeed influenced by the 2% inflation target rather than by actual inflation. The wage-settlement policy platform of the Industrial Trade Unions states that "[The Riksbank’s inflation target] is an important starting point for the labor-market parties when they negotiate about new wages... In negotiations about new wage settlements, the parties should act as if the Riksbank will attain its inflation target."

The figure below shows the empirical inflation-unemployment relationship in Sweden from 1976 to 2012. The long-run Phillips curve was approximately vertical in the 1970s and 80s. The observations on the far right are the economic crisis of the early 1990s. The points in red are the inflation targeting regime. The downward-sloping black line is the estimated long-run Phillips curve for this regime with average inflation below the credible target. You can see two black dots on the line, at 2% inflation and at 1.4% inflation (the average over the period). The distance between the dots on the unemployment axis is the "excess unemployment" that has resulted from maintaining inflation below target. The unemployment rate would be about 0.8% lower if inflation averaged 2% (and presumable lower still if inflation averaged slightly above 2%).

Source: Svensson 2014

Can this analysis be applied the the United States? Even though the U.S. has only had an official 2% target since January 2012, Fuhrer (2011) notes that inflation expectations have been stabilized around 2% since 2000, since the Fed was presumed to have an implicit 2% target. The figure below plots unemployment and core CPI inflation in the U.S. from 1970 to 2012, with 2000 and later in red. Like in Sweden, the long-run Phillips curve is downward-sloping in the (implicit) inflation-targeting period. Since 2000, however, average U.S. inflation was 2%, so overall there was no unemployment cost of sustained below-target inflation. The downward slope, though, means that if we get into a situation like Sweden's where we consistently undershoot 2%, which could result if the target is treated more like a ceiling than a symmetric target, this would have excess unemployment costs.

Source: Svensson 2014

Svensson concludes with policy implications:

"I believe the main policy conclusion to be that if one wants to avoid the average unemployment cost, it is important to keep average inflation over a longer period in line with the target, a kind of average inflation targeting (Nessén and Vestin 2005). This could also be seen as an additional argument in favor of price-level targeting...On the other hand, in Australia, Canada, and the U.K., and more recently in the euro area and the U.S., the central banks have managed to keep average inflation on or close to the target (the implicit target when it is not explicit) without an explicit price-level targeting framework.  

Should the central bank try to exploit the downward-sloping long-run Phillips curve and secretly, by being more expansionary, try to keep average inflation somewhat above the target, so as to induce lower average unemployment than for average inflation on target?...This would be inconsistent with an open and transparent monetary policy."