Europe on the brink. United States risks double-dip recession. Financial turmoil threatens world economy. Not the sort of headlines you would associate with a Nobel-prize-winning contribution to the progress of humanity. To their credit, recipients Christopher Sims of Princeton and Thomas Sargent of New York University did develop methods and models that are wisely used by economists around the world, including central banks. But it’s unclear what practical applications their findings have for the world’s current economic predicament.
Once seen as an extreme, even imprudent notion in the corridors of respectable central banking, the idea that a little bit of inflation is needed to let some of the air out of a decades-long debt bubble is gaining ground in establishment economics. Even the U.S. Federal Reserve, a central bank that prides itself in offering a high degree of steady predictability on inflation, is now actively pondering taking more drastic steps, such as linking the path of interest rates to the direction of unemployment or inflation.
These are just a few of the (printable) words analysts have used to describe the August release of the Philadelphia Fed’s factory activity index.
The Fed this week took the unprecedented step of putting interest rates of virtual permahold for a set period of time — in this case, until the middle of 2013. That’s a long time away, and the promise underscores just how concerned about the central bank is about the U.S. economic outlook. In the short-run, it looked a clever trick, stemming a precipitous slide in global stock markets. (The hint that it might be prepared to take even further action didn’t hurt either). But will the Fed’s doubling-down on its “extended period” pledge work to support a flagging economic recovery when other, stronger unconventional monetary tools have already been deployed to questionable avail?
When calibrating monetary policy, central bank officials often turn to the Taylor rule, a useful construct for thinking about the relationship between unemployment and inflation pioneered by John Taylor, former Treasury official and Stanford economics professor. So as the U.S. economy appears to falter and investors begin to speculate on the prospect of another round of monetary stimulus from the Federal Reserve, it’s worth checking in with Taylor’s model.
from The Great Debate:
By Mark Thoma
The opinions expressed are his own.
Reuters invited leading economists to reply to Mark Thoma’s Op-Ed on the “great divide” in economics and will be publishing the responses. Here are responses from Ashwin Parameswaran, James Hamilton, Dean Baker, Lawrence Summers, and a recap of Paul Krugman’s.
The following are highlights from a Reuters interview with Philadelphia Federal Reserve Bank President Charles Plosser on Wednesday.