Estimating Key Economic Variables: The Policy Implications
Acknowledging that "every economic recovery has its own unique puzzles," Federal Reserve Bank of Boston President Eric Rosengren explored two from the most recent recovery: first, the difficulty central banks in many developed economies have had achieving their inflation objectives even as employment has rebounded; and second, the relatively slow rate of economic growth experienced in the U.S., despite unusually low interest rates.
One possible explanation for the first puzzle, the difficulties in achieving inflation objectives, could be that the "natural rate" of unemployment – the unemployment rate that is consistent with an inflation rate at its target value – may have fallen.
"A lower natural rate of unemployment in the economy might explain why lower actual levels of unemployment are not driving up wages and prices as quickly as some have expected," Rosengren said.
But he cautioned, long-term economic trends are the main source of variation in the natural rate, and such changes are unlikely to occur quickly or in unexpected ways over relatively short time periods.
Rosengren noted that a common explanation for the second puzzle – the slow rate of economic growth in the U.S. despite unusually low interest rates – has been a fall in the equilibrium interest rate (the interest rate that in the long run is consistent with stable inflation and full employment).
"The rapid decline in estimates of the equilibrium interest rate should also be viewed cautiously," he said, citing the imprecision in estimation – and given how much estimates have varied over a relatively short time period.
"History shows that policymakers tend to place too much weight on short-term fluctuations in their real-time estimates of long-run concepts."
While it is important that monetary policy be "data dependent," Rosengren said, it is equally important that it not be "too sensitive" to incoming data – especially when estimating important underlying economic concepts like the natural rate of unemployment and the equilibrium interest rate.
Acknowledging that underlying economic relationships can and do change, Rosengren said one should not be too quick to assume that relationships are unhinged as a result of near-term variations.
This is of more than academic interest. "Too much sensitivity to incoming data can cause monetary policy to be too easy in expansions and too slow to respond to recessions."
Specifically, in Rosengren's view, maintaining negative real short-term rates once we have achieved full employment risks the potential of an eventual overheating of the economy. Prudent risk management, he said, would argue for the continued gradual removal of monetary policy accommodation in order to minimize the risk of outcomes that might prematurely shorten the current economic recovery.
Rosengren was speaking at the 84th International Atlantic Economic Conference in Montreal, hosted by the International Atlantic Economic Society.