Yellen Era Begins With Good Sense and Predictable Pushback

Janet Yellen testified before Congress for the first time Tuesday as the Federal Reserve Chair. Besides the excruciatingly long time that the House Financial Services Committee extended the hearing, a couple of other things stood out.

First, in terms of having a Fed chair display good judgment about the real problems facing the economy, yesterday’s testimony was awfully encouraging. Previously, the Fed had highlighted a 6.5 percent unemployment rate as a threshold (not an automatic trigger) indicating that the economy was recovering well, and hence short-term interest rates might be raised. But over the past year, the overall unemployment rate has improved much faster than other labor market indicators, and may well be painting too rosy a picture about the overall health of the economy.

Yellen made it clear that she thinks one needs to look at a wide range of indicators—particularly wage and price inflation—to assess the underlying degree of slack. And this wider range of indicators argues pretty strongly against monetary tightening anytime soon, and she seemed pretty upfront about this. By the way, for those wanting a look at some of these alternative indicators, you can check out this page on our State of Working America site. We think the employment to population ratio for prime-age workers is about as good as a single indicator gets in assessing the overall degree of labor market slack. And while it has started moving encouragingly up in recent months, it remains very far away from its pre-recession peak.

Second, a monetary policy mantra from conservatives who don’t want policymakers—either fiscal or monetary—to aggressively move to lower unemployment has been resuscitated: the Fed needs to engage in rules-based monetary policy. One supposes this sounds sober and appropriately skeptical about any government institution’s ability to “fine-tune” the economy, and has the additional benefit of being strongly associated with conservative icon Milton Friedman. Unfortunately, it’s completely inapplicable to the U.S. economy post-Great Recession.

The argument regarding “rules-based” policy was never that the Fed should ignore an economic calamity and engage in no policy changes in response to it. Milton Friedman, for example, certainly never argued that the rate of base money supply growth in 1927 and 1928 was of course the entirely appropriate rate of growth for 1929 and 1930 even as bank failures cascaded.

Allan Meltzer, one of today’s leading proponents of “rules-based” policies and a hard-money critic of the Bernanke/Yellen policy regime was pretty forthright about this, by the way, at a testimony before the monetary policy subcommittee of the House Financial Services Committee last March. Asked directly whether or not one could institute a one-size fits all stable money rule in the midst of a severe downturn, Meltzer answered flatly “no” (you can see the testimony here, and go to 2:00:50 for the beginning of the exchange). And, just in case anybody thinks that we’re not still in the midst of a severely depressed economy, I’d refer you again to this chart.

Finally it’s worth noting that the argument that containing ever-threatening inflationary pressures through rule-based policies should be central banks’ central priority was really driven by the experience of the 1970s. One can argue that the 1970s inflations were too influential in later thinking (I make that case here and Jamie Galbraith makes it more persuasively here), but regardless of whether or not you believe that, it’s clear that the high-inflation 1970s is not the world facing us today. The figure below charts one measure of core inflation since World War II. Does the recent 5 years (or even 15!) look anything like the era that convinced (too many) macroeconomists that rules-based pre-commitment was needed to discipline out of control inflationary forces?