The labor market will recover, with or without the Fed

I recently read by a paper by Laurence Ball, which advocated the use of a “high pressure economy” to bring the unemployment rate down to low levels. I’m generally opposed to that sort of policy, as I believe it leads to a procyclical monetary policy—high inflation during booms and low inflation during recessions. That makes the business cycle more unstable.

I initially assumed that it was a recent article, but rereading the piece I saw it was actually from March 2015. That provides slightly more justification for an expansionary monetary policy, but it also raises another interesting question. Consider this prediction:

FOMC members want to accommodate this return to long-run equilibrium while avoiding an overheating of the economy that would push inflation above target. Based on FOMC statements, it appears likely that the Fed will pursue its goals by raising short-term interest rates above their current near-zero levels at some point around the middle of 2015.

This essay argues that a different path for monetary policy would be better for the economy. The Fed should seek to push the unemployment rate well below 5%, at least temporarily. A likely side effect would be a temporary rise in inflation above the Fed’s target, but that outcome is acceptable. To push unemployment down, the Fed should keep interest rates near zero for longer than is currently expected, certainly past the end of 2015.

Notice that Ball thought it would take high inflation to push unemployment down below 5%.  Instead, unemployment has fallen to 4.3% with inflation actually remaining slightly below the Fed’s 2% target (currently it’s closer to 1.5%).

I’ve never believed in “hysteresis” theories that claim unemployment can get stuck at high levels due to a lack of aggregate demand.  I think this theory was based on a misdiagnosis of the European labor market after 1980, where the high unemployment that was assumed to be labor market slack was actually caused by statist labor market regulations.  In the US, the unemployment rate will fall back to the natural rate regardless of whether the Fed pushes inflation above their 2% target.  Thus it’s better for the Fed to focus on stable NGDP growth, and let the labor market take care of itself.

If you want more jobs (and I do), then advocate supply-side labor market reforms.

PS.  A recent piece by Paul Krugman points out that the fall in unemployment to 4.3% also refutes claims made during the recovery period that the high unemployment was partly “structural”.  I was also skeptical of the structural unemployment claim, but even I did not expect unemployment to fall quite this low.

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