I have known Janet Yellen for a long time. She is a good economist, a pioneer in efficiency-wage modeling, and a successful Chair of the Federal Reserve. But, in one aspect of the Fed’s management of interest rates, she continues to make a consequential mistake. In testimony before the House Financial Services Committee last a week ago, she reiterated that inflation persisting below the Fed’s target 2% rate could disrupt FOMC plans to tighten credit conditions: “Its premature to reach the judgment that we are not on the path to 2 percent inflation over the next couple of years. We’re watching this very closely and stand ready to adjust our policy if it appears the inflation under-shoot will be persistent.”
The emphasis on inflation, independent of labor-market behavior, implies that the Fed believes one or both of the following. The performance of the U.S. economy would improve if price inflation could be pushed to a 2% path rather than the neighborhood of 1% occurring today. And/or the current below-target product-price path is signaling some sort of impending cyclical disturbance in economic growth. Both are wrong.
Yellen’s mistake in rooted in mainstream thinking and illustrates a central message of the GEM Project. Stabilization-relevant theory, which the academy’s consensus market-centric macroeconomics is demonstrably not, is needed in the adequate design and execution of monetary policy. In particular, the Fed in its acceptance of the mainstream New Keynesian version of the micro-coherent, market-centric, general-equilibrium model class is placing two analytic bets. The first is the academy’s central monetary-policy conclusion: Product-price inflation provides information that is superior to unemployment in guiding stabilization efforts. Second, interest rates exert the dominant influence on the behavior of total output, employment, and unemployment. Both bets are wrong.
The GEM Project has shown that generalized-exchange theory is consistent with the broad range of cyclical evidence and is, among available micro-coherent models, uniquely relevant to effective stabilization policymaking. In two-venue general-equilibrium analysis, the relationship between product-price inflation and unemployment is substantially enriched from mainstream market-centric theory. Mediating influences in GEM thinking that are missing in textbook analysis include catch-up to consumer price inflation, venue differences in product-price inflation, shifts in labor’s terms of trade, expectations restricted to the inflation regime, relative venue size, the implicit long-lagged recalibration of existing wage rent, sectoral labor productivity, and government intervention.
The additional complexity, recognizable to practitioners, implies that empirical estimates of simple reduced-form Phillips relationships must be interpreted with great caution. The generalized-exchange model class additionally shows, consistent with the evidence, that interest rates are not nearly as important as mainstream theory indicates. In the two-venue approach and actual behavior, pure-profit expectations are by far the dominant influence both on investment spending and the cyclicality of total nominal spending and on the trend behavior of productivity. Don’t macroeconomists, at least deep down, know that. Everybody else does.
The GEM Project’s micro-coherent generalized-exchange model combines with the relevant evidence to support intuitive monetary policy. It shows that the Fed’s assigning priority to their inflation objective relative to their unemployment objective, implicit in Yellen’s testimony, is simply wrong-headed. Inflation is undeniably important but that significance in the current circumstances is trumped by the behavior of employment and unemployment. The labor market is operating near full employment and is clearly signaling the need to return to more normal credit conditions.
Some friends of the GEM Project persist in questioning why it is necessary to raise interest rates if inflation is, for whatever reason, low. Three reasons are conclusive. First, easy money in the circumstances of full employment creates distortions that are breeding grounds for asset-price bubbles and macro instability. The Fed got itself in hot water after the mild 2001 recession for holding the fed funds rate at 1% into full employment, feeding the strong upward push of many asset prices occurring at that time, That failure in stabilization management has been much criticized and never adequately explained. The key question today is whether it is a lesson learned.
Second, easy money in circumstances of full employment harms the class of investors that are natural buyers of financial assets that minimize default and market risk. Consider two examples. Elderly investors rationally prefer to avoid default/market risks rooted in periodic instability but, given the persisting low yields of Treasury debt, are being forced to swallow hard and ignore their strong preferences. Meanwhile, firms with particular fiduciary obligations – insurance companies, pension managers, etc. – are frequently required to allocate a significant share of their asset pools to Treasury debt. Their longstanding business plans have been fundamentally damaged, with yet unmeasured future consequences, by the Fed insistence on easy money in a full-employment economy.
Third is a reiteration of a critical, poorly understood, point. There is little real-side benefit to persistent easy money in the circumstances of full employment. Low interest rates lose most of their capacity to generate incremental investment spending on equipment, structures, and software and consequently greater employment and production in a full-employment economy.
On all three points, the Fed is greatly misled by their reliance on evidence-inconsistent market-centric New Keynesian macroeconomics. Monetary authorities are relying on a deeply inadequate description of the true relation between product-price inflation and unemployment/ investment in highly specialized economies. Today’s policy mistakes are another instance of the outsized damage caused by modern mainstream Ptolemaic modeling.
Blog Type: Policy/Topical Saint Joseph, Michigan