It seems pretty clear to me that a monetary contraction isn’t the appropriate policy response to a supply shock. Apparently there are those within the Federal Reserve who see things differently.
Last week’s statement from the Federal Reserve acknowledged that the damage from Katrina could well mean both lower output and higher inflation:
Output appeared poised to continue growing at a good pace before the tragic toll of Hurricane Katrina. The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term….
Higher energy and other costs have the potential to add to inflation pressures….The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.
With those words, the Federal Reserve bumped the fed funds rate up to 3.75% at its meeting last week, and the market seems to expect another increase at the next meeting as well.
First of all, let’s be clear about terminology here. Just because the Fed has been raising the interest rate at each FOMC meeting for over a year, we shouldn’t think of yet another rate hike as representing no change in policy. The Fed may care about both output and inflation, but over a short time horizon it only has the tools to address one objective at a time. In raising the interest rate in the current environment, the Fed is making a deliberate policy choice to sacrifice the output goal in order to achieve a more favorable result for inflation.
How should news that we’re going to perform worse in terms of both objectives lead us to re-evaluate the tradeoff between the two? The answer depends in part on how you think about fluctuations in the unemployment rate. The graph at the right displays the unemployment rate in the U.S. over the last half century, with recessions indicated by shaded areas. One striking feature about this series is the fact that the unemployment rate tends to rise much more quickly than it falls. Statistical confirmation that this is an important feature of the data is reviewed in this recent paper. To me this asymmetry suggests that there is a potential cascading effect of an economic downturn– if a large enough mass of people lose their jobs, that fact in itself creates an impetus for even more layoffs. Once that process begins, the economy goes into a recession too quickly for the Fed to be able to prevent it. I would argue that the most important guideline for the Fed in terms of balancing the growth and inflation objectives is to make sure that the efforts to keep inflation low never go so far that they cause us to enter that regime of a rapidly spiking unemployment rate.
The issue is that the recent supply shocks have surely increased the probability of that happening. Rapidly rising energy prices have often preceded economic recessions. Although prior to August the oil price increases had developed gradually enough that the economy was largely able to adapt, my earlier concerns about airlines (here and here) were borne out last week by Delta Airline’s announcement that it intends to eliminate 9,000 jobs. The rapid rise in gasoline prices since August did seem to cut into retail sales, and the post-Katrina plunge in consumer sentiment must be interpreted as a very loud warning bell. The destruction of New Orleans also looks to me like an event that could have
significant macroeconomic consequences. Ed Leamer
may be correct that a recession won’t occur without a housing downturn. But if perceptions about housing price appreciation and the economic outlook change, a housing downturn could come pretty quickly, and certainly there are some signs already of a cooling housing market (, ).
Even apart from the supply shock, we do have some historical experience with what happens when the Fed raises interest rates by 275 basis points in a little over a year, as they’ve just done. When the Fed did the same thing in 1959, 1969, 1973, 1978, and 1989, we ended up in a recession. On the other hand, in 1984 and 1995 we managed to dodge the bullet.
I suppose that the Fed thinks it’s smart enough to take its foot off the brake at just the right moment this time around, too. But how do we know when “just the right moment” is? Didn’t the Fed think it was being smart in 1959, and 1969, and 1973, and 1978, and 1989 as well? I agree with Socrates that wisdom comes from being aware of what you do not know. We don’t yet know what the macroeconomic implications of Katrina will prove to be. If the Fed really wants to be smart, it will wait until we have a better understanding of that before kicking rates up yet another notch.