Monetary policy

WRITING on the surprisingly strong January jobs report, my colleague says:

Will the better tone to the jobs market deter the Federal Reserve from further monetary easing? Not yet. Ben Bernanke, the Federal Reserve chairman, acknowledged the moderately better tone to economic data yesterday, but the last official Fed statement and press conference strongly suggested the Fed is inclined to do more quantitative easing; we’d have to get more, and better, reports like this one to take that option off the table.

I agree that this report probably isn't enough to change the Fed's outlook. The jobs numbers beat expectations, but labour market improvement isn't a surprise to anyone; the private sector has been adding nearly 200,000 jobs a month for the past six months. When the Fed met in late January it knew things were better than they'd been in a while, if not quite this good. The report certaintly shouldn't deter the Fed from taking additional action. Even if the natural rate of unemployment has risen as high as 6.5%, the present unemployment rate of 8.3% implies quite a lot of labour market slack. Inflation has been falling in recent months, and the latest employment report shows that earnings growth has been muted, even as the pace of hiring has increased.

At the same time, I am a little concerned. The Fed's latest economic projections—which, remember, assume that the FOMC is following an appropriate monetary policy—have a central tendency for the unemployment rate of 8.2% to 8.5% in 2012. It's only February, and the figure is already at the low end of that range. Future inflation, as implied by 2-year breakevens, is up noticeably for the week, and rose above 2% on today's good news.

If we were to take the Fed at its word when it says that its projections imply optimal monetary policy, then we'd have to conclude that absent a deterioration in the labour-market situation in February any new easing would be off. The FOMC might even find itself walking back some of its commitment to low rates through 2014.

That would be a bad thing. Because rates are stuck near zero, an increase in inflation expectations is precisely what is needed to facilitate labour-market clearing. To get that, the Fed needs to signal that it's prepared to tolerate a bout of catch-up inflation. Ben Bernanke came close to doing so in the press conference after the January meeting. It might find the question impossible to dodge in March. I'm sure there will be a strong temptation to back off plans for new purchases; Mr Bernanke took significant flak for previous purchase programmes, and those weren't announced in the months prior to a presidential election.

I hope the Fed can stick to its plan. Because what we're observing now is an increase in the effectiveness of accommodative monetary policy. The problem, as I see it, has been that policy has not been loose enough to clear labour markets, mostly because it's hard to move the policy rate down to the market-clearing real interest rate when the market-clearing real interest rate is negative. As the labour market improves, however, the market-clearing real interest rate becomes less negative and inflation expectations rise, making the policy rate more negative. That's the technical way of putting it. The not-so-technical way of putting it is simply that the outlook for income and spending growth is improving. That means that businesses don't need to be prodded as hard to hire and invest, and because they're hiring and investing more the outlook for income and spending growth is improving. 

We could have gotten here long ago, given suitably aggressive Fed action. It would have been a little harder. Earlier in the deleveraging process, for instance, the market-clearing real interest rate was more negative: more households were struggling with debt burdens, which meant that more spending and investing was required of the economy's relatively few financially healthy institutions. To gin up that spending and investing, a much more negative return on savings was required—too negative, it seemed, for the Fed to feel comfortable targeting it. That's a shame.

Happily, however, things have moved in a useful direction and the Fed has responded appropriately. It would be an even bigger shame—a tragedy, really—if the Fed took the possibility of smoother sailing as a chance to duck hard choices rather than to finally allow the American economy the recovery it deserves.