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In the Nation's Interest


By Joe Minarik
Senior VP & Director of Research

My lifetime hero, the economist Arthur Okun, used to liken the difficulty of making monetary policy to a hapless early-morning shower-taker, who alternately scalds and freezes himself by over-correcting the temperature controls back and forth in search of the right balance.  If I thought that I ever could improve on anything that Okun said, I might suggest an alternative metaphor of trying to cook an egg on an electric stove top, and after frustration at the slow pace of cooking and turning the heat up several times, suddenly finding the pan far too hot and the egg burning.

The point is the phenomenon of thermal inertia, where the frying pan and the stove burner are first reluctant to accept heat, and then equally reluctant to give it up.  This comes to mind when thinking about the recent Jackson Hole meeting about monetary policymaking at the Federal Reserve.

According to press accounts, the Jackson Hole speakers as a group emphasized the current need for a continued emphasis on macroeconomic stimulus via monetary policy.  This raised in some minds the persistent question of whether the Fed should in fact be charged, as it is now, with a dual mandate of maintaining both price stability and full employment.  You don’t need to look very far to find people who believe that the Fed should have a single mission of maintaining price stability, and should leave employment concerns to the fiscal authorities or the free market.

Personally, I find the single-mandate alternative to be singularly unsatisfying.  For one thing, if the Fed truly were to care solely about price stability, the one way to ensure it would be to keep the economy as flat as a pancake.  (If on the other hand the single goal were to maintain full employment, the Fed should pave the streets with money.)  I don’t believe that my argument is a cheap shot.  As soon as you acknowledge that the Fed should stop short of either extreme policy, you are asking how the Fed should balance those two objectives of price stability and high employment, rather than to follow a single-purpose policy.

A second reason to accept the two objectives of monetary policy, as opposed to leaving full employment to the fiscal authorities – i.e. the Congress – is that those fiscal authorities have so much difficulty acting in the first place, and then reversing themselves when necessary.  The Congress does love to stimulate the economy by cutting taxes or increasing spending.  But even then they can argue after action clearly is needed.  And even if such policies are labeled explicitly as temporary, the Congress has a hard time allowing them to expire.  It is as though Okun’s shower-taker were the proverbial one-armed economist, who therefore could not turn the hot water down.

The Federal Open Market Committee (the Fed’s policymaking arm), by contrast, can fill the punchbowl as fast as it can schedule a conference call.  And thereafter, it has shown no compunction about taking the punchbowl away just as soon as the partygoers show any signs of getting a little too rowdy.

That is a question of process over the long haul.  But there is a question of the direction of policy in the near term, and that is whether the Fed is making the right choice in its apparent current emphasis on boosting employment.  Some have feared for price stability on the ground of stimulative Fed policy for pretty much the entire duration of the response to the financial crisis.  Could they finally be right?  Has the Fed overplayed its hand?

Every conscientious Federal Reserve Governor or Bank President is asking him- or herself that question right now.  But I believe that there are two points in favor of the current apparent concentration on the employment problem.

The first is actually a relatively neutral point, that the balance between inflation and unemployment truly is a two-sided risk.  This point gets back to the thermal inertia metaphor.  Since the 1970s, monetary policy makers have been highly conscious of inflationary momentum, or psychology, or expectations – choose your term.  Once inflation gets going, it can be very painful and costly to stop.  Our experience here in the United States lends credence to this concern.  This is why many people fear that the Fed will go too far and will build inflationary expectations back into the system, and that it will be difficult and costly to dispel those expectations.

But the experience of Japan since about 1990 has made clear that deflationary expectations also can build an inertia of their own.  If the Fed were to show excessive deference to fears about inflation, it could fall into the opposite pit, and have just as much trouble climbing out.

So how do we judge whether the employment problem today is truly serious enough to build its own inertia?  Let me paint the one picture that to me suggests the magnitude of the shock that our economy endured in the financial crisis.  It shows the ratio of inventories (both wholesale and retail) to sales in the U.S. economy.  Historically, when demand falls, businesses are left holding unexpectedly large inventories, and that is why they must cut back on employment and purchases, and why and how a recession propagates itself throughout the economy.

The “scale” of this chart, if you will, is the 2001 recession, just to the left of the horizontal center of the picture.  Contrast that small bump in the inventory-to-sales ratio, caused by and signifying a certified, card-carrying recession, with the monumental leap of inventories in the financial crisis.

No one knows the future.  But I am left from data such as in the chart above with the unshakable sense that our economy has been through a wringer, and will be some time in recovery.  I believe that the Fed is being prudent to want to see a meaningful, self-sustaining expansion before they risk falling back into a Japan-style deflation.  That does not mean the maintenance of quantitative easing; the unwinding of that policy already is well underway.  But it does mean prudence about tightening too much, too soon, and falling into the inertia of deflation, rather than assuming that only inflation can attain such inertia and impose enduring costs on the economy.  Both hot and cold can be painful, and I have confidence that our monetary policymakers understand that.