A Plea for More Flexibility on Monetary Policy

One of my pet peeves about U.S. economic policy over the last few years has been the Federal Reserve Board’s obsession with a bit of economic conventional wisdom known as the “natural rate” of unemployment.

Throughout its modern history, the Fed has rightly decided whether to raise interest rates by trying to gauge whether inflation is about to reignite--thus eroding genuine economic growth.

But too often in recent years, the Fed has based its inflation forecasts on a rather arbitrary determination of whether the national unemployment rate has declined too much, thus overheating the economy and putting unbearable pressure on prices.

The Fed came to rely far too much on what economists call the “natural rate of unemployment.” That is, the lowest level of unemployment that can be sustained without sparking renewed inflation. Economists claimed to know what the “natural rate” was down to a fraction, and so the Fed began to use the “natural rate” as a trigger mechanism. If unemployment went below that level, the Fed would raise interest rates.

But the latest smoke signals from Fed headquarters at Constitution and C streets in Washington now suggest a fundamental shift in thinking, and raise a question that has the entire economics profession talking: Has the “natural rate” lost its allure for Alan Greenspan?

There’s no doubt that at some point in the business cycle, low unemployment--and high employment--create price pressures. No one has yet repealed Econ 101: Inflation does follow when labor demand outstrips labor supply.

The problem comes when the Fed--and fellow traveling inflation-hawk economists--claim they have found the precise level of unemployment at which that happens. They compound their error when they enshrine that number for all time, as if it is an unchanging scientific formula that should form the basis of U.S. monetary policy.

Such thinking leads almost immediately to an elitist view of economic policy, a belief that Washington must simply write off a significant portion of the labor force.

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Traditionally, the economics profession held that full employment occurred in the U.S. economy when the unemployment rate fell to about 4%. But in the early 1990s, Fed officials came to believe that the “natural rate” of unemployment was far higher, perhaps 6% or more--meaning that many Fed officials believed that the nation’s central bank should begin to raise interest rates whenever the nation’s unemployment rate fell below that level. Some economists, searching for their new Holy Grail, claimed to have determined that the natural rate was precisely 6.4%.

Fed economists based that conclusion on a detailed study of the previous 30 years of America’s economic performance. What’s more, inflation hawks at the Federal Reserve Bank of Kansas City received widespread attention within the Fed system when they argued that the natural rate might even be close to 7%.

Few Washington policymakers were willing to challenge that orthodoxy; in 1993 and 1994, Clinton administration economists argued that the natural rate might be slightly lower--maybe 5.5%--but certainly not much lower.

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Yet just as quickly, that conventional wisdom is coming unraveled. Today there seems little doubt that the Fed is quietly abandoning its basic assumptions about the natural rate and no longer believes it is 6% or higher. Fed Chairman Greenspan has not made any public announcement disowning the natural rate, but his actions speak loudly enough.

At the most recent session of the Federal Open Market Committee--the Fed panel that decides interest rate policy--officials left interest rates unchanged, even though the nation’s unemployment rate has been hovering just above 5% for months. Now odds are that the Fed will not raise rates for the rest of the year.

The reason for the change of heart is obvious: Economists now agree that the idea that the natural rate was 6% or higher was flat wrong. Unemployment has now remained below 6% for two years with little visible impact on inflation. And the natural rate theory holds that inflation should begin to rear its ugly head at least within a year of when the unemployment rate falls below the natural rate.

Fed officials have been befuddled by the total failure of their economic models and have been forced back to the drawing board. “We would have expected to see inflation by now,” a puzzled Fed Gov. Lawrence Lindsey told reporters in September. “We don’t.”

In an interview with Bloomberg Business News in September, Lindsey added what may be the closest thing yet to capitulation on the natural rate by a senior Fed official: “We are clearly more tolerant of higher levels of employment than the economic consensus of a few years back suggests that a central bank should be.”

Conservative economists worry that a backlash against the incorrect assumptions that led to a belief in a very high natural rate will now convince policymakers that they can ignore the concept of a natural rate altogether. There is a natural rate, they argue. It’s just not as high as we thought.

In fact, the nation’s jobless rate--at 5.2% in September--is probably close to the natural rate now.

Economists now acknowledge that their estimates of the natural rate were so far off because they were fighting the last war. They based their analysis of the relationship between inflation and employment on historical trends--ignoring the fact that the U.S. economy was undergoing a remarkable transformation just as they were compiling their 30-year-old data.

Maybe those Fed economists haven’t gotten out much. Maybe they haven’t had to look for a job for a while. But they still should have recognized that the economy of 1996 looks nothing like the economy of 1966. Have they heard about Intel, Netscape and Microsoft? Starbucks and Home Depot? Fidelity and Vanguard? The Stealth fighter and cellular phones? Japan’s decline and China’s rise? BMW’s car factory in the American South?

“What has been embarrassing is that precisely as this wave of research in the early 1990s was generating natural rate estimates around 6.4%, based mainly on the record of the three prior decades, the natural rate apparently was falling, and fast,” observed a sheepish Edmund S. Phelps, an economist at Columbia University, in a recent op-ed piece in the Wall Street Journal.

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That brings us back to my pet peeve. Economists exhibited enormous professional hubris when they tried to divine a precise “natural rate” for all time. They forgot that the economy doesn’t stand still for their laboratory experiments.

Let’s hope the economics profession will learn from its mistake, accept the fact that the “natural rate” is organic and flexible, and use that knowledge to propose more creative fiscal and monetary policies for the future. They need to think about how natural rate theory works in the real world of the late 1990s.

And they can start with the debate over welfare reform: How can the economy absorb the new low-wage job-seekers who will enter the labor force once they are thrown off assistance by this year’s welfare reform legislation?

The welfare bill establishes a lifetime limit of five years for welfare payments to any family and will require most adults to work within two years of receiving aid. But if the economy is already running close to full capacity, will the Federal Reserve accommodate these new job-seekers? Will the central bank ease up on interest rate policy in order to find room in the economy for these former welfare recipients?

Now that economists have acknowledged their earlier mistakes on the natural rate, maybe they will be brave enough to argue for further flexibility on monetary policy as well.