It’s fair to say, I think, that the question posed in the title of this blog post is at the heart of any monetary policy debate.
Here’s how the discussion went at the June meeting of the Federal Open Market Committee (FOMC):
“Meeting participants again discussed the extent of slack in labor markets. Some participants judged that the unemployment rate was being substantially boosted by structural factors such as mismatches between the skills of unemployed workers and those required for available jobs….One implication of the view that there is relatively little slack is that providing more monetary stimulus would be likely to raise inflation above the Committee’s objective. Some other participants acknowledged that structural factors were contributing to unemployment, but said that, in their view, slack remained high and weak aggregate demand was the major reason that the unemployment rate was still elevated. These participants cited a range of evidence to support their judgment….These arguments imply that slack in labor markets remains considerable and therefore that a reduction in the unemployment rate toward its longer-run normal level would not have much effect on inflation.”
If you want more specifics about these contrasting views, you might find recent speeches by some FOMC meeting participants helpful. Jeff Lacker, president of the Federal Reserve Bank of Richmond, is pretty clearly in the “relatively little slack” group:
“It’s worth noting…that the effects of unemployment insurance benefits together with the effects of labor market inefficiencies could plausibly account for a quite substantial portion of our elevated unemployment rate. The quantitative estimates of labor market mismatch come from independent methods and datasets and, in principle, measure conceptually distinct inefficiencies. We shouldn’t necessarily assume these effects are additive, but combining all three together yields a range of 2.9 to 5.9 percentage points, which is sizable relative to the increase in the total unemployment rate of 5-½ percentage points during the recession.”
Vice Chairman Janet Yellen is also pretty clearly on the other side of the debate:
“A critical question for monetary policy is the extent to which these numbers reflect a shortfall from full employment versus a rise in structural unemployment. While the magnitude of structural unemployment is uncertain, I read the evidence as suggesting that the bulk of the rise during the recession was cyclical, not structural in nature.
“Consider…the difference between the actual unemployment rate and the Congressional Budget Office (CBO) estimate of the rate consistent with inflation remaining stable over time…[the] index of the difficulty households perceive in finding jobs…[and the] index of firms’ ability to fill jobs….All three measures show similar cyclical movements over the past 20 years, and all now stand at very high levels.”
The positions outlined above lay bare why estimates of the output gap command such weight in the discussion of monetary policy—both ends of the FOMC’s dual mandate of maximum employment and price stability may run through it. If the output gap is large, that is, if the level of gross domestic product (GDP) is running significantly under potential GDP, the economy is obviously not in a position of maximum employment. And if that is the case, the inflation trend is likely to be headed lower and so the price stability mandate may also be in jeopardy.
Where do I come out in this debate? That isn’t important since I don’t get a vote. But my boss, Dennis Lockhart does, and he laid out his position in a recent speech to the Mississippi Economic Council.
“I think the output gap—the amount of slack in the economy—is neither as sizeable as the high-end estimates, nor is it zero. If there were no slack at all, 8.2 percent unemployment would represent full employment. If this were so, the economy would have undergone profound structural change over the last five years. As I weigh the findings of research by Federal Reserve economists and others, I do not think a compelling case has yet been made that structural adjustment has played a dominant role in slowing growth and progress against unemployment.
“If, on the other hand, slack in the economy were close to the high estimates, we should have seen more and more persistent downward pressure on prices and wages than has, in fact, been the case. Deciding on the extent of the output gap is not straightforward. I believe the truth is in the gray middle.”
To emphasize, this “gray middle” isn’t a compromise but a weighing of the available evidence. If the GDP gap really is close to zero, the profound structural change that the economy ought to have experienced hasn’t found great support in the data. But if this is just a bigger version of gaps of recessions past, then where is the great disinflationary pressure such slack would ordinarily imply?
You may have another view and, again quoting Lockhart’s recent speech, “reasonable people can consider the issues…and come to different conclusions. “And if you’re having trouble getting a grasp on GDP, potential GDP, and why the measurement of our national potential isn’t an easy task, perhaps we can help. We’ve recently produced an educational video on the issue. It’s not a deep treatment of the issue—in fact, just the opposite. It’s a jumping-in point for those who are interested in the policy debate but haven’t a clue what a GDP gap is. As always, let us know what you think.