Federal Reserve Chairwoman Janet Yellen is proposing to try something that the central bank is not supposed to be able to do: improve the supply side of the economy.
Yellen has sketched out what could be a justification for keeping the Fed’s interest rate target lower for longer, influencing rates on products throughout the economy, including mortgages, credit cards, cars and more. It’s an idea that last popped up at the Fed twenty years ago, eliciting unease from a younger Yellen who was then a subordinate to Fed Chairman Alan Greenspan.
Yellen laid out her logic in a speech in Boston this month, saying that, with further loose money, the Fed might be able to drive unemployment so low that businesses become desperate for workers and are forced to hire marginal applicants. In running such a “high-pressure economy,” Yellen said, the Fed may be able to “reverse [the] adverse supply-side effects” of the recession, namely the damage done to workers’ experience and abilities wreaked by soaring unemployment.
Usually, it is thought that the Fed can’t affect supply-side factors that determine long-term growth, such as the education level of the workforce. The belief is that the central bank can address only the demand side of the economy in the short run, by manipulating the money supply and interest rates and thereby swaying more or less spending on goods and services.
Yet Yellen is questioning that division.
She noted in a press conference last month that in the past year there has been evidence that people who had quit looking for jobs during the recession are being brought back into the labor force and finding jobs, as businesses add positions month after month even as the unemployment rate hovers just above the Fed’s estimate of the full employment rate.
If those long-unemployed people could get their foot in the door, they might be able to develop skills on the job and work their way up to better jobs, Yellen reasoned. In turn, businesses might spend more investing in equipment or space for them. In the process, the U.S. would become more productive — in other words, the supply side would be improved.
Just what Yellen means by “high-pressure economy” is uncertain because there’s no fixed definition, but analysts have taken Yellen to mean something like an economy in which the unemployment rate falls below the rate that Fed officials believe would represent a fully healthy economy, or the “natural rate” of unemployment.
The opposite of a “high-pressure economy” is what economists call “hysteresis.” Hysteresis is the theory that long spells of high unemployment can hurt the supply side by atrophying the skills of jobless workers, making short-run weakness and high unemployment partly self-perpetuating. The term was coined to describe the high-unemployment western European economies in the 1970s and 1980s.
There are fewer historical episodes of high-pressure economies. The term has been applied to the economy of the mid- to late-1990s, when the unemployment rate fell to 5 percent, below where economists thought it would settle in the long run, and kept dropping. “It was a goldilocks economy,” said Bob McTeer, the former Federal Reserve Bank of Dallas president who sat in the Fed’s meetings alongside Yellen.
As the unemployment rate fell, employers, in urgent need of help, began to revamp their hiring practices, according to a study of the era done by the Georgetown labor economist Harry Holzer. Businesses started to consider, and hire, groups of people who would have been ignored in other times, including minorities, welfare recipients and those with little experience.
At the time it was happening, however, some at the Fed were worried. In theory, keeping money loose when the unemployment rate is below the natural rate should generate inflation, as too much money chases too few workers and too few goods.
The Fed’s staff, recounted McTeer, became “increasingly fearful that a breakout of inflation was right around the corner.”
Yellen, who was then serving as a member of the Fed’s Board of Governors under Greenspan, tried to take action.
Laurence Meyer, another governor at the time, described the episode in a blog post for his current company, Macroeconomic Advisers. Before the September 1996 meeting, he and Yellen confronted Greenspan. They told him that “we loved him but could not remain at his side much longer if he continued” to delay raising rates. Greenspan heard them out, but didn’t commit to anything.
At that meeting, the transcript shows, Yellen warned that the economy was in an “inflationary danger zone.”
But by November, her mind was changing.
What had given her pause, she explained at the Fed’s November meeting, was a Businessweek article describing that Marriott hotels were teaching workers low-level workers English to move them into positions with more responsibilities.
If large companies were training up the kinds of people who are typically afterthoughts, she thought there may be benefits to Greenspan’s loose monetary policy worth the risk of higher inflation that she saw. Those businesses’ investments in training workers were “on the flip side of the hysteresis process” that played out in Europe, she said.
In hindsight, it seems that there was little risk of too-high inflation. The jobless rate would ultimately fall to below 4 percent in the 1990s, without stoking the out-of-control inflation that Yellen and others feared. Why not? Greenspan reasoned that productivity was rising thanks to the advance of technologies such as the Internet, putting downward pressure on inflation. Economists now mostly credit Greenspan for recognizing that the natural rate of unemployment was lower than others thought.
The question now is whether Yellen is willing to delay rate hikes even longer to run a high-pressure economy and, in particular, whether she would be willing to risk higher inflation to do so. Too-high inflation might be a more serious threat now than in the 1990s, given that productivity appears to be falling, not rising. She might be risking pushing unemployment below the natural rate in a way Greenspan did not.
Yellen has made clear that she favors waiting for longer. After the September meeting, she said that, with inflation below the Fed’s 2 percent target, she wants to give the economy “room to run” before tightening monetary policy to bring people on the sidelines back into jobs.
She hasn’t said explicitly, however, that she would be willing to see inflation rise above the Fed’s 2 percent target to make that happen.
Some economists think that temporary above-target inflation would be necessary to see the kind of supply-side-enhancing job gains Yellen wants to see. “It’s fine to talk about ‘we want a high-pressure economy, we want to create jobs, we want to do lots of things,’ but when you’re saying we’re going to have inflation converge to 2.0 [percent] and not a bit above that, then that constrains what you can really do,” said Laurence Ball, a Johns Hopkins professor who last year wrote a paper calling for monetary policy aimed at a high-pressure economy.
And, if Yellen did delay rate increases in the face of rising inflation, she would face opposition from within the Fed. Speaking at an event in New York in October, Fed Vice Chairman Stanley Fischer said that it would be fine to allow the unemployment rate to drop a few ticks below the natural unemployment rate. “But saying we should keep going until the inflation rate shows us we’re wrong, then you’re going to change too late,” Fischer said.
At least a few other members of the Fed share Fischer’s view, the minutes from the group’s September meeting indicate. An unidentified number of members of the central bank raised the concern that driving unemployment too low in the past had resulted in the Fed having to then hurriedly raise rates, prompting recessions.
Ball suggested that the Fed might be able to push unemployment as low as 4 percent before encountering above-target inflation. And letting inflation rise to 2.5 percent or so — or even setting a higher target — would not be bad, he argued.
A recent research note from Goldman Sachs researchers, however, said it was “speculative” that running a hot labor market could yield supply-side benefits, based on the fact that the housing bubble job market didn’t result in lasting productivity gains for marginal workers who gained jobs then. Whether try to run a high-pressure economy, thereby risking inflation, is a “live debate” at the Fed, the bank economists said.
As Greenspan showed in 1996, however, when he overruled Yellen and kept interest rates low, the Fed chairman is ultimately the one to make the call.
