Is the Fed Near Its Target?

The BLS reported on Friday that the U.S. unemployment rate fell all the way to 6.3% in April. That marks significant progress in terms of thebull’s eye of Fed accountability proposed by Federal Reserve Bank of Chicago President Charles Evans which Econbrowser discussed 2 months ago. The unemployment rate has dropped steadily over the last 4 years with no increase so far in the inflation rate.

Horizontal axis: civilian unemployment rate.  Vertical axis: inflation rate as measured by year-over-year percent change in implicit price deflator for personal consumption expenditures.  Center point represents FOMC "longer run" economic projections.  Crosses denote values for April unemployment and Q1 year-over-year inflation for indicated year.  Adapted from Evans (2014). Horizontal axis: civilian unemployment rate. Vertical axis: inflation rate as measured by year-over-year percent change in implicit price deflator for personal consumption expenditures. Center point represents FOMC “longer run” economic projections. Crosses denote values for April unemployment and Q1 year-over-year inflation for indicated year. Adapted from Evans (2014).

Civilian unemployment rate, Jan 2007 to Apr 2014, along with Fed's long-term 5.5% objective.  Data source: FRED. Civilian unemployment rate, Jan 2007 to Apr 2014, along with Fed’s long-term 5.5% objective. Data source: FRED.

The current unemployment rate of 6.3% is actually slightly below the average 6.4% that the U.S. economy has experienced since 1970. But while the labor market is starting to look more normal according to conventionally measured unemployment, other labor market indicators remain distinctly unhealthy. The number of Americans who have been looking for work for longer than 6 months is still higher than it had been even at the worst of any previous postwar recession.

Source: FRED. Source: FRED.

And last month’s improvement in the unemployment rate came entirely from a drop in the labor force participation rate. Some individuals who reported in March that they were out of work and actively trying to find a job (in which case the BLS counts them as “unemployed”) instead reported in April that they are still not working but did not actively look for a new job within the last four weeks (in which case the BLS counts them as “not in the labor force”). To be sure, much of the decrease in the participation rate seems attributable to long-term demographic factors, as the decline was evident well before the Great Recession.

Source: FRED. Source: FRED.

Even so, while the distinction between “unemployed” and “not in the labor force” might be a sharp one from the point of view of the definitions of the BLS, as a practical matter for many potential workers it clearly is not. In any given month, the number of people who change from being “not in the labor force” to “employed” is always greater than the number of people who change from being “unemployed” to “employed”, suggesting that many of those counted as not in the labor force may in fact be more interested in getting a job than some of those counted as unemployed.

Red: number of people who were employed in month t but not in the labor force in month t-1. Black: number of people who were employed in month t and unemployed in month t-1.  Source: Veracierto (2011). Red: number of people who were employed in month t but not in the labor force in month t-1. Black: number of people who were employed in month t and unemployed in month t-1. Source: Veracierto (2011).

And ongoing research by UCSD Ph.D. candidate Hie Joo Ahn finds that it is common in the underlying individual BLS data records to find a given individual who was reported to be “not in the labor force” in month t-1 but self-reports in month t as being unemployed and having been looking for work for the last six months. Again, that’s something that makes perfect sense if you think in terms of actual people instead of narrow statistical definitions, provided you recognize the blurred practical boundaries between being “unemployed” and “not in the labor force”.

Turning next to inflation, the Fed’s second objective, despite the improving unemployment rate the U.S. inflation has continued to drift below the Fed’s long-term target of 2%. That means that if you summarize their score card in terms of the “bull’s eye” in Figure 1 above, the fact that inflation is now about 1% below target is a bigger “miss” for the Fed than the fact that unemployment is still 0.8% above target.

Year-over-year percent change in quarterly implicit price deflator for personal consumption expenditures, 2007:Q1 to 2014:Q1, along with Fed's long-term 2.0% objective.  Data source: FRED. Year-over-year percent change in quarterly implicit price deflator for personal consumption expenditures, 2007:Q1 to 2014:Q1, along with Fed’s long-term 2.0% objective. Data source: FRED.

Here again there are other indicators one could propose using for the Fed’s scorecard. Tyler Cowen and Josh Zumbrun call attention to a curious anomaly. For a number of years, MIT professors Alberto Cavallo and Roberto Rigobon have been managing the Billion Prices Project, which collects prices off the internet daily to form an objective summary of what customers actually pay to purchase products online. For 2011 and 2012 the BPP measure coincided very closely with the conventional consumer price index calculated by the BLS. But for the last two years, BPP has measured inflation as coming in a half percent above the Fed’s target instead of 1% below as the CPI and PCE deflator have been signaling.

Year-over-year percent change in prices as measured by BPP (red) and CPI (blue). Source: Billion Prices Project. Year-over-year percent change in prices as measured by BPP (red) and CPI (blue). Source: Billion Prices Project.

A separate question is whether inflation below 2% in and of itself is a bad thing, as Figure 1 implicitly assumes. In the theoretical models currently most in use by macroeconomists, an increase in expected inflation would help stimulate spending and thereby provide further help on the unemployment front. But Bachmann, Berg, and Sims (2014) find little evidence in support of this assumption from individual household data, and Mian and Sufi question the common presumption that higher house prices would provide much stimulus to spending in the current environment. A recent study of mine with Bank of Canada researcher Christiane Baumeister found using Bayesian methods that if you started with a prior belief that higher inflation raises aggregate demand, U.S. data since 1986 would cause you to change your mind, favoring the view after seeing the data that higher inflation is more likely to lower demand than increase it.

My bottom line on all this is as follows. Although a casual look at the April data might leave one thinking we’re getting pretty near the Fed’s ultimate objectives, the preponderance of evidence argues that the economy still needs more stimulus. And while I am not as sold as some other analysts on the idea that more inflation in and of itself would be a good thing, I think that until we receive clear evidence that inflation is coming in significantly higher than it was during 2011-2013, the scales are still tipped in the direction of wanting to see additional stimulus.

Notwithstanding, this strikes me as a less unambiguous call than it was a year or two ago. The key indicator to watch for is whether traditional inflation measures make a very clear move up. If that happens, we would have to acknowledge the possibility that long-term unemployment and falling participation rates may not be problems that monetary policy can do much about. For now, however, they still look like important issues that should factor into the Fed’s deliberations.

This piece is cross-posted from Econbrowser with permission.