Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Thursday, August 10, 2006

The Thoughtful and Reliable Edmund Andrews on the Federal Reserve and a "Soft Landing"

He writes:

Economy Often Defies Soft Landing - New York Times: In the cool and quiet marble corridors of the Federal Reserve, the strategy for taming inflation sounds painless, even soothing: a “soft landing” for the economy after several years of flying high. As the central bank contended on Tuesday, when it decided to pause in its two-year effort to raise interest rates, inflation is “elevated” right now but will begin to decline because economic growth is poised for a modest slowdown. Many economists, though, warn that the soft landing may seem anything but soft, and suggest that the Fed is either too rosy about the looming slowdown or naïve about the difficulty of reaching its goal for inflation.

In practice, the Fed has achieved only one true soft landing — in 1994-95, when, under the leadership of Alan Greenspan, it was able to slow the economy enough to cool spending and ease inflation pressure but not so much as to cause a big jump in unemployment. But even Mr. Greenspan, whose ability to fine-tune policy made him famous, presided over two formal recessions, in 1991 and in 2001. This time, many analysts say that the Fed and its new chairman, Ben S. Bernanke, face considerably tougher challenges. Crude oil, at more than $70 a barrel, is selling at prices that would have been unthinkable in 1995. Productivity growth, which was accelerating in 1995, is slowing these days. The dollar, which was climbing against other major currencies in 1995, is declining against most of them now.

Analysts and other experts say that if Mr. Bernanke is serious about his goals for controlling inflation, at least two million more workers may have to lose their jobs over the next two years. “The economic slowdown has to be much more substantial than anybody in the Federal Reserve or on Wall Street is expecting,” said Robert J. Gordon, a professor of economics at Northwestern University, who has analyzed the trade-off between inflation and unemployment for the last several decades. Mr. Bernanke and other Fed officials say they want to keep core inflation, the main measure of retail prices excluding energy and food, below 2 percent a year. But core inflation is already 2.9 percent and almost certain to climb as the cost of oil pushes up prices for items as diverse as air fares and plastics.

Mr. Gordon said the last few decades had shown a grim but consistent trade-off: to reduce inflation by one percentage point, the unemployment rate has to rise by about two percentage points for a full year. To reduce inflation to the upper limits of what Mr. Bernanke and other Fed officials consider acceptable, more than three million jobs would be lost, a bigger drop than in the recession of 2001. And that is Mr. Gordon’s relatively upbeat hypothesis, which assumes no other shocks to the economy — no additional increases in energy prices, no collapse in the dollar’s value, no collapse in housing. “I think the Fed is facing an absolutely classic case of stagflation,” Mr. Gordon said, “a situation in which they cannot win.”

He is not alone. Many other economists contend that inflation is more entrenched and will be more painful to reverse than the Fed thinks. Others predict that inflation will indeed subside, but only because the economy will weaken much more than the Fed is expecting. The chief forecaster at Decision Economics, Allen Sinai, said unemployment would have to rise to at least 5.5 percent, from 4.8 percent today, putting a million more people out of work, before inflation begins to decline.

The chairman of Roubini Global Economics Monitor, Nouriel Roubini, predicted that the economy would fall into a recession early in 2007 as a result of high energy prices, higher interest rates and a housing collapse. “Either the Fed does not believe its own inflation forecast, which I don’t think is the case,” Mr. Roubini said, “or the slowdown is going to be greater than what they have been saying. They can’t have it both ways.” To be sure, economists differ on how weak the economy already is or how severe inflation pressure is. And skepticism abounds on the chances of achieving a true soft landing.

The very idea of such a thing is only about a decade old. It was conceived by Mr. Greenspan, then the Fed chairman, as a way to attack inflation before it started, by shrewdly using the levers of monetary policy to slow the economy just enough to keep it from overheating. Mr. Greenspan’s greatest success was in the mid-1990’s, when the economy had been expanding for nearly four years. Though inflation was declining and was lower than it is today, the Fed doubled short-term interest rates, to 6 percent from 3 percent, in just over a year. At the time, the result seemed neither soft nor smooth. Several financial institutions, caught by surprise, found themselves in big trouble. The economy slowed for a while, and unemployment edged up. But by 1996, the economy was rapidly growing again and the nation enjoyed several years of booming stock markets, falling unemployment and relatively low inflation.

The success, along with Mr. Greenspan’s growing aura as a wizard of monetary nimbleness, prompted the Fed to step in and help soften the blows of the Asian financial crisis of 1997-98, the stock market collapse of 2000, the recession of 2001 and the surge of unemployment that followed. He failed in preventing the 2001 recession, but the Fed cut interest rates so deeply that this started a boom in housing prices and home refinancing that kept consumers spending even as incomes stagnated and unemployment moved higher.

Laurence H. Meyer, a former Fed governor and now a chief forecaster at Macroeconomic Advisers, said Mr. Bernanke needed to do more than simply duplicate Mr. Greenspan’s one soft landing. Mr. Greenspan was not trying to reduce inflation, but merely to keep it from going up. Mr. Bernanke, by contrast, is trying to reduce it substantially. “Soft landings are much more frequent in forecasts than in real life,” Mr. Meyer said. “With a computer, I can give you a soft landing if you give me 10 or 20 runs. But in real life, you only have one run.”

Uncertainties and disagreement among experts about the economy’s direction are now unusually high. A big uncertainty is whether the nation is near full employment. Many economists contend that the country is essentially at full employment, meaning that additional demand for workers will tend to push up wages. Because wages account for more than three-quarters of total production costs, Fed officials view them as inflationary if they rise significantly faster than productivity. Specialists like Mr. Gordon at Northwestern and Mr. Meyer maintain that the labor market is already very tight and predict that wages will soon start to push up inflation. But others disagree, arguing that wages over the last five years have lagged behind increases in productivity and have barely kept up with inflation. The bigger risk, according to that school of thought, is to make the situation worse by driving up unemployment.

“We have no clue about labor market tightness right now,” said J. Bradford De Long, a professor of economics at the University of California, Berkeley, who argues that workers still have little bargaining power. Depending on one’s perspective, Mr. De Long said, the Fed’s attempt at a soft landing is either a display of cool-headed technocracy or murky witchcraft. Right now, he said, “this is on the witchcraft side.”


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