Uneasy Money

On his blog, Steve Williamson discusses the recent (September 29, 2011) speech by Charles Plosser, President of the Federal Reserve Bank of Philadelphia, to the Business Leaders’ Forum at the Villanova School of Business.  Plosser explains why he disagrees with recent moves by the Fed such as forward guidance about keeping short-term interest rates at current low levels, and operation twist to lengthen the maturity structure of the Fed’s asset holdings.  Williamson likes the speech; I don’t.  So let’s explore my reasons for disagreeing with Plosser and Williamson.

The first half of the speech reviews the current economics situation, the slow recovery from the 2008-09 downturn and financial crisis, and the deteriorating economic situation since the beginning of the year, despite what Plosser calls “the extraordinary degree of monetary accommodation” provided by the Fed, resulting in a tripling of the size of the Fed’s balance sheet, and a shift in holdings “from mostly short- to medium-term Treasuries to longer-term Treasuries, mortgage-backed securities, and agency debt.”  Furthermore,

In August, the FOMC changed its guidance about its expectations for the future path of the federal funds rate. In particular, it stated that economic conditions were “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” At its meeting last week, the FOMC announced additional accommodative action. In an effort to reduce long-term Treasury yields from already historically low levels, the FOMC intends to purchase $400 billion of longer-term Treasury securities and to sell an equal amount of shorter-term Treasuries by the end of June 2012.

Plosser goes on to defend his dissent from the recent FOMC decisions, arguing that the ineffectiveness of past monetary stimulus in reducing unemployment should serve as a warning to “be cautious and vigilant that our previous accommodative policies do not translate into a steady rise in inflation over the medium term even while the unemployment rate remains elevated.”  In other words, monetary accommodation has proven ineffective in reducing unemployment, but it may cause inflation in the future, and without reducing unemployment in the process. 

How is that possible?  Wouldn’t an increase in aggregate demand resulting from an easy money policy tend to increase inflation while reducing unemployment?  Plosser thinks not, because monetary expansion could create “an environment of stagflation, reminiscent of the 1970s [that] will not help businesses, the unemployed, or the consumer.” 

This seems to me a most remarkable assertion.  The experience of the 1970s used to be viewed as evidence that the long-run Phillips Curve is vertical, so that monetary policy can’t force the unemployment rate down permanently below its “natural” level, because ultimately, when the price level effects are foreseen, workers will not let themselves be fooled into accepting lower real wages than they are really willing to work for.  From this proposition, Plosser apparently infers that even if there is unemployment, because (in a Phillips-curve framework) real wages are too high to allow a full-employment equilibrium, you can’t use monetary policy to reduce the real wage, because workers won’t let their real wage be reduced by inflation even when the real wage is above its equilibrium level. 

This is actually a curious inversion of Keynes’s argument about the futility of nominal wage reductions as a method or eliminating unemployment.  Keynes held that falling nominal wages would simply be passed through by employers to customers in the form of lower prices, negating the nominal wage cut.  The logic by which Keynes concluded that falling nominal wages would cause a proportionate fall in prices rather than a less than proportionate fall in prices to restore equilibrium was far from ironclad; one could argue at least as plausibly that firms would not be quite so obliging as to pass forward their full savings from reduced money wages to consumers without trying to increase their depressed profit margins even a smidgen.  Similarly, Plosser seems to be suggesting that workers, despite high levels of unemployment, are so determined to preserve their current above-equilibrium real wage that any increase in prices tending to reduce real wages would elicit immediate and effective demands by workers for increased nominal wages thereby negating the incentive to hire additional workers otherwise following from an increase in prices relative to wages.  If this is the lesson Plosser draws from 1970s stagflation, it is a very different lesson from the one that Friedman and Phelps thought that they were teaching when they formulated the natural rate hypothesis 40 years ago. 

The only other possibility is that Plosser thinks that the natural rate of unemployment is now approximately 9%.  Perhaps it is, but if that is what he thinks, he ought to be willing to make that argument explicitly and not pretend that he is simply applying the lessons of the 1970s.

But Plosser seems to be making just that suggestion in the next paragraph of his speech (quoted approvingly by Williamson).

In my view, the actions taken in August and September tend to undermine the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery. It is my assessment that they will not. We should not take certain actions simply because we can. . . . The ills we currently face are not readily resolved through ever more accommodative monetary policy. If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined. The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future.

Plosser offers an assessment that the actions taken by the FOMC in August and September cannot affect the speed of the recovery.  I agree with that assessment, because monetary policy has failed to change pessimistic expectations about the course of future prices and nominal incomes.  Plosser, however, apparently believes that monetary policy could not under any circumstances do any more than it already has.  But he seems unwilling to defend his assessment that monetary policy cannot reduce the current rate of unemployment in terms of any commonly understood macroeconomic model.  We are supposed to just take his word that monetary policy cannot help speed the adjustment of an unemployment rate above its natural level back to its natural level.  So unless Plosser believes that the current unemployment rate is already at its natural level, I cannot understand how he could suggest that a policy of moving the unemployment rate down toward its natural level is tantamount to asking the Fed to “solve all our economic problems.”  And if he thinks that the unemployment rate is now at the natural rate of unemployment, he ought to say that that is what he thinks and explain why he thinks that is the case.

Steve Williamson supports Plosser with the following observation:

A large fraction of the population is significantly worse off than they were in 2007. But there are no monetary policy actions available currently that will make them better off. However, by continuing to engage in unconventional policy actions – QE1, QE2, “forward guidance,” and Operation Twist, the Fed is acting as if it knows what it is doing, and can actually reduce unemployment by taking those actions. Further, public statements by some Fed officials, particularly Bernanke, express confidence that these actions actually work. Bernanke, and like-minded people such as Charles Evans, Chicago Fed President, are unfortunately engaged in wishful thinking.

What is the wishful thinking here?  Is it that speeding the adjustment of unemployment toward the natural rate will make the reduction in unemployment unsustainable?  What is the theory that explains why speeding a reduction in unemployment to the natural level is unsustainable?  What evidence supports such a view?  Or is that the natural rate of  unemployment is now at 9%.  And again I ask, what is the basis for believing that the current natural rate is now at 9%?