FRBSF's John C. Williams — The Slow Recovery: It’s Not Just Housing

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The Slow Recovery: It’s Not Just Housing
By John C. Williams

(h/t Mark Thoma)

Goes through the state of the economy as the FRBSF views it. Summary — the economy is improving steadily but is still underperforming and the Fed needs to be on it with policy.

If you just want the meat of it regarding policy, here it is. Read it and weep.

Outlook for unemployment

As I said earlier, the news from the labor market has been heartening. The jobless rate has fallen about three-quarters of a percentage point since August and is now at its lowest level in three years. Unfortunately, the kind of moderate economic growth I expect won’t sustain such rapid progress. The February unemployment rate held steady at 8.3%. I expect unemployment rates to remain around 8% through year-end. And we’re still likely to be around 7% at the end of 2014. We haven’t had such a long period of high unemployment in the United States since the Great Depression. And this phenomenon is widespread. Compared with December 2007, when the recession began, the unemployment rate is up in all 50 states. That’s true even in North Dakota and Alaska, the two states where total employment grew during the recession.

Economists have been debating why unemployment has been so high during this recovery. Broadly speaking, they fall into two camps. One group argues that changes in the structure of the economy are pushing up the unemployment rate. The other group maintains that high unemployment is the result of a severe downturn, which significantly cut demand for goods and services.

Those who favor a structural explanation point out that many job seekers lack the skills employers need. For example, computer industry employers are having a hard time finding qualified workers. But they’re not likely to find such employees in the ranks of jobless construction workers. If such labor market mismatches are widespread, they could be boosting the unemployment rate.

To put this in perspective, I’m going to introduce the concept of the natural rate of unemployment. The natural rate is basically an equilibrium jobless rate that pushes inflation neither up, nor down. Before the recession, most economists thought this rate was around 5%. Today though, economists in the structural camp argue that the natural rate has risen substantially, largely because of the labor market mismatches I described. The idea is that a lot of people are unemployed not because jobs are lacking, but because those jobs require skills unemployed workers don’t have. If this were correct, then our 8.3% unemployment rate might not be that far above the natural unemployment rate. In other words, we might not really be so far from the Fed’s goal of maximum sustainable employment.

I’m not convinced. Research at the San Francisco and New York Feds suggests that job mismatches are limited in scope. The difficulty some Silicon Valley companies find hiring software engineers is not enough to fundamentally transform the labor market. Now, other factors besides skill mismatches may also have helped push up the natural unemployment rate. Over the longer term, mismatches and other labor market inefficiencies may have raised the natural unemployment rate from about 5% to around 6 to 6½% (see, for example, Daly et al. 2012 and Weidner and Williams 2011). So, in my view, the nation remains far from the Fed’s goal of maximum sustainable employment.

Outlook for inflation

The Fed’s other goal is to keep prices stable. I would say that we’ve succeeded pretty well on that score. Inflation overall has been well-contained. Taking a long view, over the past 15 years, the overall inflation rate has averaged almost exactly 2%, which is the Fed’s target rate of inflation. The same is true of the past five years, a tumultuous period of crisis, recession, and recovery.

Now, it’s true that inflation picked up to 2½% last year as the prices of oil and other commodities surged in the face of strong global demand. Oil prices have run up again recently in response to geopolitical concerns. But other commodity prices have not generally followed suit. I expect inflation to be near our 2% target this year and edge down a bit to about 1½% in 2013.

Let me summarize where the Fed stands in terms of achieving its congressionally mandated goals. We are far below maximum employment and are likely to remain there for some time. The housing bust and financial crisis set in motion an extraordinarily harsh recession, which has held down consumer, businesses, and government spending. By contrast, inflation is contained and may even fall next year below our 2% target.

Under these circumstances, it’s essential that we keep strong monetary stimulus in place. The recovery has been sluggish nationwide, not just in states hit hard by the housing bust. High unemployment, restrained demand, and idle production capacity are national in scope. These are just the sorts of problems monetary policy can address. And we don’t need to worry that our stimulative monetary policy could fuel regional imbalances.

Monetary policy’s role in the recovery

Monetary policy works by raising and lowering interest rates. The Fed’s policymaking body is the Federal Open Market Committee, or FOMC. In December 2008, when the recession’s full force hit, the FOMC slashed its benchmark interest rate close to zero. It’s been there since. Standard monetary policy guidelines tell us this rate should have gone deep into negative territory. But that’s not possible (see Rudebusch 2009 and Chung et al. 2012 for discussion of the effects of the zero bound on interest rate policy in the recession and Swanson and Williams 2012 for estimates of the effects of constrained monetary policy).

So the Fed has had to find other ways to stimulate the economy. One measure we’ve adopted has been to buy large quantities of longer-term securities issued by the U.S. government and mortgage agencies. Our purchases have raised demand for these securities, lowering their yields. And that has put downward pressure on other longer-term interest rates, making it cheaper for households, businesses, and governments to borrow.

These policy actions have been effective. For example, recent gains in automobile sales have a lot to do with cheap financing. And our securities purchases have helped drive longer-term interest rates near to post-World War II lows. In particular, our purchases of mortgage-related securities appear to have lowered home loan rates significantly. (Hancock and Passmore 2011 and Krishnamurthy and Vissing-Jorgensen 2011 find significant effects of mortgage-backed securities purchases. Stroebel and Taylor 2009, by contrast, do not.) Low mortgage rates have been crucial in stabilizing home sales and construction.

I should emphasize that our unusually stimulative monetary policy won’t last forever. Eventually, as recovery picks up, we will trim our securities holdings and raise our interest rate target. We’ve planned in detail for this, and we’re confident we can do it in a timely and effective fashion (see, for example, the discussion of exit strategy in the minutes for the June 2011 FOMC meeting in Board of Governors 2011). But, that time is still well off in the future.

We’ve passed through extraordinary economic times that have required extraordinary responses from the Fed. We’re not miracle workers. Lower interest rates alone can’t instantly put the economy right. But things would be much worse if we hadn’t acted so forcefully. We were vigilant in 2008 and 2009 when the economy was in dire straits. We remain vigilant now, when the economy is showing real signs of improvement, sharply focused on our goals of maximum sustainable employment and price stability.