Wall St. And Business Wednesdays: E-Letter To Congressman Mel Watt Re: Federal Reserve Monetary Policy And NAIRU
I am really looking forward to Federal Reserve Chairman Alan Greenspan’s appearance before your committee tomorrow, and I anxiously await your opportunity, in particular, to question him. At the end of our recent interview you asked that I share with you my thoughts regarding monetary policy and the Black economy, and today, I am happy to do so, in hopes that it will help you as you prepare to engage Mr. Greenspan, a man, who for over a decade, the business and even mainstream media have referred to as the “most powerful” in the world.
Let me begin by sharing with you the excerpt of our interview that I want to focus on:
Cedric Muhammad: Very good. Well, I have to tell you that one of the things that excites me tremendously about you being chairman of the CBC is your background – you represent a district that includes Charlotte, North Carolina, a banking capital and you have tremendous understanding of financial markets. And I have been of the opinion that when it comes to Federal Reserve policy and on certain issues as it pertains to Black-owned banks, we have just not had strong Black political leadership. So I wanted to know how do you think you would bring a greater spotlight on issues like Federal Reserve monetary policy, because my opinion has been that the Black Caucus tends to defer too much to Congressman Barney Frank on monetary policy. I think he does a very good job but I think there are certain nuances to the Black economy that he misses. So I wanted to know, how do you view your chairmanship in light of your background and would you be able to put a greater spotlight on these issues?
Congressman Watt: Well, I would like to. I think I bring a particular perspective in these issues. In addition to monetary policy of course, there is predatory lending in the Black Caucus agenda because it is disproportionate in our community - redlining and insurance redlining. That kind of stuff. We need to highlight those issues because those are areas in which if we make different policy choices, if we choose to reduce unemployment as opposed to devoting all of our attention to keeping down inflation, for example. That is kind of where Alan Greenspan is always focusing. He’ll say , OK, 10% unemployment is better than having higher inflation. But, if you kept lowering interest rates, inflation might go up more but employment would go up also. So we have tried to convince Alan Greenspan and the whole Federal Reserve System that keeping interest low and keeping access to capital available and thriving minority banks and businesses is an important part of the economy. And he is not always looking at that as much as we would like for him to. But we will just have to keep that in the spotlight.
Cedric Muhammad: One of your colleagues who has been pretty strong on one point of criticism of Chairman Greenspan, and really the Fed institutionally is – and you just alluded to it – Rep. Jesse Jackson, Jr. He has been critical of this adherence by the Fed to the failed economic theory of “The Phillips Curve” or NAIRU (the non-accelerating inflation rate of unemployment), this idea that there is a direct correlation between employment and inflation. Blacks and others should be sensitive to this because it basically amounts to the United States being committed to a structural level of unemployment and an economy that is intentionally prevented from growing. Are you convinced that the Fed has abandoned its institutional allegiance to this theory and the policy prescription that grows out of it that essentially maintains that unemployment must be kept down in order to prevent inflation?
Congressman Watt: No, I am not convinced that they have abandoned it. I think what has happened during the Clinton years is that we saw that you could have much, much, lower unemployment than they had ever thought could exist; and that this unemployment could peacefully co-exist with low inflation. So, it kind of exploded the myth that in order to keep inflation low you had to keep unemployment high. And that myth was exploded during the Clinton years. We had low unemployment and we had low inflation. Productivity was growing at tremendous rates because of advances in technology. So that was helping to drive the process. But I am not sure that they have abandoned that construct. They still believe it.
I was so pleased to hear you tell me that although you know that NAIRU is a myth that was disproved by the economic performance of the 1990, you are convinced that the Federal Reserve has not abandoned it. Congressman, I too, am convinced that they have not abandoned it. And until they do, I do not think it bodes well for the American economy, but particularly for Black Americans in the economy – as laborers, entrepreneurs, business owners, and capital providers. There are so many people enamored with the U.S. economic performance of the 1990s that they believe the debate on NAIRU is over and it is an open and shut case regarding whether the theory should guide policy makers. I think this confident and comfortable attitude has and continues to cause many people who would otherwise be concerned with Federal Reserve monetary policy to ignore how the legacy of an economic theory that originally gained prominence in the 1960s is still influencing monetary policy decision-making at the highest levels. The popular perception may imply otherwise but evidence of the thinking inside of the Federal Reserve shows that NAIRU and its variants are far from dead in the mind of policy makers.
Essentially the problem is two-fold. One, there was, in the late 1990s, and still is attachment to NAIRU within the Federal Reserve and those influencing its members, despite the 1990s economic data that clearly appears to disprove the theory. And, secondly, the Federal Reserve, even when it acknowledges problems with NAIRU feels it has no other alternative to guide its decision making.
On the first factor, while the 1990s apparently intellectually defeated adherence to NAIRU, there still exists an influential group of economists who believe that the 1990s actually did not disprove NAIRU. Some argue that the strong dollar, the increased use of stock options, and productivity, all clouded the supposedly clear relationship that NAIRU essentially argues exists: lower unemployment leads to higher wages which lead to higher prices. The NAIRU defenders argue that it was these external factors (an overvalued dollar, stock options and productivity gains) that kept inflation low although unemployment was at record lows. To get to the heart of the matter, individuals like Dr. Alan Blinder, who served as Vice Chairman of the Board of Governors of the Federal Reserve System from June 1994 until January 1996, and Janet Yellen, the current President and CEO of the Federal Reserve Bank of San Francisco, and Member of the Board of Govenors of the Federal Reserve System from 1994 to 1997, believe this, and openly wrote about it together in 2002, in "The Fabulous Decade Macroeconomic Lessons From The 1990s" . And Federal Reserve Chairman Alan Greenspan openly discusses how he thinks productivity gains (labor productivity is how much one worker produces in one hour), in particular, may have accounted for new dynamics in the American economy affecting labor markets in the 1990s and today. He has referred to it 11 times in Congressional testimony.
For 8 years I have followed the Federal Reserve’s position on NAIRU in light of the mounting evidence that NAIRU is flawed and that the economic performance of the 1990s – simultaneous low unemployment and low measured price inflation – alone questions the legitimacy of the theory. What I have noticed is the Federal Reserve, in its debates, research papers and policy positions, vacillating, backtracking, and dissembling on the accuracy of NAIRU, but ultimately only modifying its view of the role NAIRU plays in the actual monetary policy decision-making process. What has struck me in particular is the Federal Reserve’s growing embrace of the modification that it is not NAIRU as it has been defined that matters as much as it is “short-run NAIRU”. “Short-run NAIRU” is a more narrow view of NAIRU over only 12 month time periods, that its proponents believe more accurately indicates the factors influencing inflation and employment outside of the normal business cycle.
The Federal Reserve argued in the late 1990s and continues to do so this decade, that “short-run NAIRU” is a better measurement than 1) the natural rate of unemployment ( the unemployment rate that would be observed once short-run cyclical factors have played themselves out, usually in between one and two years) or 2)NAIRU (the concept of a natural rate of unemployment). You can read a San Francisco Federal Reserve Research Paper in FRBSF Economic Letter 98-28; September 18, 1998, “The Natural Rate, NAIRU, and Monetary Policy”, authored by Carl E. Walsh, that argues that the Federal Reserve could use a “short-run NAIRU” standard to make better monetary policy decisions. But more importantly, in a January 2, 2001 paper, “NAIRU Uncertainty And Non-Linear Policy Rules” published by Federal Reserve Board of Governor Laurence H. Meyer (Federal Reserve Governor from 1996 to 2002), and Federal Reserve Board Of Governors Economist, Eric T. Swanson, you can read an open admission that uncertainties about NAIRU have caused the staff of the Fed Board of Governors to “continuously update its estimate of NAIRU – specifically short-run NAIRU – during this period and the updated estimate of the NAIRU likely influenced to some degree the decisions of some members of the FOMC."
The second factor in the overall problem is the reality that although NAIRU has been challenged theoretically and in application it will not be discarded until it has a replacement. Carl E. Walsh argued this in his paper for the Federal Reserve Bank of San Francisco when he wrote: “The NAIRU has been subject to much criticism, yet it continues to appear in policy discussions. In part, this reflects the failure of alternative simple guides to monetary policy. At one time, many argued that growth rates of the monetary aggregates provided useful guides for conducting monetary policy, but in the 1980s, the relationship between monetary aggregates, inflation, and economic activity appeared to break down, reducing their role in policy discussion. Until a clearly superior guide that can help to forecast future inflation comes along, the NAIRU is likely to continue to figure prominently in discussions of monetary policy."
In 2001 I openly challenged Federal Reserve Chairman Alan Greenspan to acknowledge that the price of gold had proven to be the "superior guide that can help to forecast future inflation" the Fed seems unable to locate. Chairman Greenspan used to acknowledge this utility of gold but has belied his own beliefs over the years as Federal Reserve Chairman.
With Chairman Greenspan in denial over his own previously-stated beliefs about gold, the Federal Reserve has languished to find standards or indicators of incipient inflation - stock market prices, housing prices and starts, productivity statistics, and various price indices. NAIRU, essentially, is an "employment standard" for the Fed to watch - guiding its manipulation of interest rates and the money supply according to whether or not a rate of unemployment has been reached that will cause wages and prices to rise.
But in a January 8, 2002 speech made by current Federal Reserve Board of Governor and Vice-Chairman, Roger Ferguson - its only Black member - remarks were made which in and of themselves should cause Federal Reserve Chairman Alan Greenspan to make a clear determination regarding the role that NAIRU or “short-run NAIRU” should play in Federal Reserve Open Market Committee (FOMC) decisions. Notice how Chairman Ferguson accurately indicates that there really is no employment standard that a central bank should target in making its monetary policy decisions:
When the central bank's mandate includes multiple goals, the quantification of objectives becomes even more problematic. For example, the Federal Reserve's mandate includes the long-run goal of maximum employment as well as price stability. How does one measure maximum sustainable employment? As several economists have noted, estimating the non-accelerating-inflation-rate of unemployment (NAIRU), one possible measure of a full-employment objective, is even more controversial than selecting a target for a specific price index. Associated estimates of an output or employment gap would have an uncomfortably wide confidence interval. Some economists doubt the validity of the concept of NAIRU altogether. Thus, the uncertainty involved with setting such a real-side target and the temptation to hold the central bank accountable for achieving any numerically specified unemployment goal at all times should discourage quantifying an unemployment target for those economies with that goal. In any event, historical evidence suggests that maximum employment is best attained in the long run by ensuring price stability and not by attempting to achieve a pre-announced quantitative employment objective.
A combination of the selected excerpts from Professor Walsh and Vice-Chairman Ferguson and their implications, essentially sums up the problems with NAIRU from the perspective of the central bank – NAIRU is problematic and not an appropriate standard for the Federal Reserve to target when making monetary policy decisions. But the problem from the perspective of Black America is that when the Fed targets NAIRU and seeks to slow the economy down in order to fight inflation, the impact on employment and access to capital is not the same for all Americans. Because unemployment is not evenly distributed and NAIRU models treat the American workforce as homogeneous, the theory does not catch the fact that when more and more of the nation’s citizens are employed, employment increases disproportionately among lower-wage workers, which are disproportionately Black. Thus, when the Federal Reserve decides to stop the rate of unemployment from going lower it is actually making a political decision about which Americans hold what jobs and earn how much. This point is made clear in the work of Jared Bernstein and Dean Baker of the Economic Policy Institute. I add, that because the Federal Reserve slows down the economy by squeezing liquidity out of the banking system or raising the price of capital (by raising interest rates) it also hurts Black entrepreneurs, small business owners and banks who, on the margin, need capital the most.
So, Congressman I hope you will consider all of this as you prepare to listen to and engage Chairman Alan Greenspan in hearings tomorrow.
I am privately sending to you two questions to consider asking Chairman Greenspan, when you have the opportunity, tomorrow.
I would include them for the benefit of the viewers of BlackElectorate.com, but that group includes Federal Reserve Banks across the country and the Board Of Governors in Washington D.C. who frequently visit the website.
For one day, I want to deprive my viewers within the most powerful institution of America’s banking elite.
You have my best wishes for your continued success.
Wednesday, February 16, 2005