Fed policy: Complicating an already complicated situation

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This post is a guest contribution by Rebecca Wilder*, author of the of the News N Economics blog.

The Federal Open Market Committee (FOMC) is making tough decisions right now. Its mandate, “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”, is a seriously tall order given current economic conditions.

The unemployment rate sits at 9.7%, while prices bounced back to 2.6% Y/Y in January. On the surface of it, inflation appears to be gaining some traction; but the big numbers are representative of base effects, and that is really all. The drag on prices remains very real.

But there is one little kink in the headline figures of unemployment that complicates an already complicated task: extended unemployment insurance. From the FOMC’s Jan. 26-27 minutes:

Though participants agreed there was considerable slack in resource utilisation, their judgments about the degree of slack varied. The several extensions of emergency unemployment insurance benefits appeared to have raised the measured unemployment rate, relative to levels recorded in past downturns, by encouraging some who have lost their jobs to remain in the labour force. If that effect were large- some estimates suggested it could account for 1 percentage point or more of the increase in the unemployment rate during this recession– then the reported unemployment rate might be overstating the amount of slack in resource utilisation relative to past periods of high unemployment.

Why would extended unemployment benefits increase the unemployment rate? In order to claim unemployment benefits, one must be “in the labour force”; and that means looking for work. Therefore, some workers who would otherwise be classified as “not in the labour force” remain in the work force as “unemployed”. Therefore, the current unemployment rate is elevated above the rate that would occur without the extended benefits. The Fed suggests this differential to be roughly 1% point.

I am in no way proposing that the extended benefits be rescinded, nor am I deluding myself into thinking that the labour market is anything short of awful. But Fed policy is calibrated to the non-inflation-generating level of the unemployment rate. And the current unemployment rate may be closer to the long-run level than the headline number suggests.

I have talked about this before (see this post) from another angle: the long-run level of unemployment may be a moving target right now, i.e., it’s likely rising. Therefore, if it is rising and subsidies are masking the true level of the current unemployment rate, then we may very well get some inflation while the economy is still weak.

Of course, I do not believe we are even near such a threshold level, but it does complicate an already complicated situation. A modified Taylor rule demonstrates the implications for policy:


The chart above illustrates the estimated Taylor Rule using the current unemployment rate (blue line) versus one in which 1% point is shaved off the unemployment rate for every month since January 2008 (green line). The modified rule does suggest the Fed policy rate is currently at (or now below) the prescribed rate.

Source: Rebecca Wilder, News N Economics, February 27, 2010.

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

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