How to weigh unemployment relative to inflation in monetary policy?

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1 Journal of Money, Credi and Banking, Supplemen o Vol. 46, No. 2 (Ocober 2014), Typos in he published version have been correced: Page 186, 3rd paragraph, 2nd line and 4h paragraph, 2nd line: Should be above a longrun susainable rae insead of below a long-run susainable rae. How o weigh unemploymen relaive o inflaion in moneary policy? Lars E.O. Svensson Sockholm School of Economics, Sockholm Universiy, CEPR, and NBER. June 2014 Absrac The moneary policy mandae for he Federal Reserve and of he Riksbank are essenially he same and boil down o sabilizing inflaion around he inflaion arge and employmen or unemploymen around a long-run susainable rae. The relaive weigh on sabilizing unemploymen or employmen versus sabilizing inflaion may be close o one. A posiive unemploymen-gap forecas normally calls for a posiive inflaion-gap forecas. JEL codes: E52, E58 Keywords: Inflaion argeing, Federal Reserve, Sveriges Riksbank Panel discussion a Fulfilling he Full Employmen Mandae, he 57 h Economic Conference a he Federal Reserve Bank of Boson, April 12-13, I hank Gabriela Guibourg and Magnus Jonsson, boh a he Riksbank, for help wih he draf of he panel discussion.

2 In hese remarks, I will firs briefly discuss he mandae for he moneary policy of he Federal Reserve and of he Riksbank. I will argue ha hey are essenially he same, and ha hey boil down o sabilizing inflaion around he inflaion arge and employmen or unemploymen around a long-run susainable rae. Second, I will discuss he magniude of he relaive weigh on sabilizing unemploymen or employmen versus sabilizing inflaion. Finally, I will say somehing abou wha inflaion and unemploymen or employmen gaps are opimal and, in he concluding secion, relae ha o he curren siuaion for he Fed and he Riksbank. The mandaes of he Federal Reserve and he Riksbank According o he Federal Reserve Ac, he Federal Reserve s mandae is o promoe maximum employmen and sable prices. In he Saemen on Longer-Run Goals and Moneary Policy Sraegy (FOMC 2014) firs issued by he FOMC in January 2012 and since hen reaffirmed or amended a he Commiee s organizaional meeing in January each year he Federal Reserve clarifies how i inerpres is mandae. I specifies he price-sabiliy objecive as an inflaion arge of 2 percen for he PCE price index. I also clarifies ha he maximum level of employmen is largely deermined by nonmoneary facors ha affec he srucure and he dynamics of he labor marke. These facors may change over ime and are no direcly measurable. Therefore i is no appropriae o specify a fixed goal for employmen; insead he maximum level has o be assessed from a wide range of indicaors, and he assessmen may change over ime. The saemen repors ha he FOMC paricipans esimaes of he longer-run normal rae of unemploymen have a cenral endency of 5.2 o 5.8 percen. In paricular, ha saemen clarifies ha, under circumsances when he pricesabiliy and maximum-employmen objecives are no complemenary, ha is, when here is a radeoff beween he objecives, he Commiee will follow a balanced approach in promoing hem. The Sveriges Riksbank Ac saes ha he objecive of he Riksbank s moneary policy shall be o mainain price sabiliy. The Governmen Bill ha inroduced he Ac o he riksdag (he Swedish parliamen) furher saes ha: 1 1 See Svensson (2013) for a more deailed discussion. 1

3 As an auhoriy under he riksdag, he Riksbank shall also, wihou prejudice o he price-sabiliy objecive, suppor he objecives of he general economic policy wih he aim o achieve susainable growh and high employmen. The Riksbank has specified he prices-sabiliy objecive as an inflaion arge of 2 percen for he CPI. In he beginning of each Moneary Policy Repor, i also clarifies is inerpreaion he above saemen in he Governmen Bill: This is achieved hrough he Riksbank, in addiion o sabilising inflaion around he inflaion arge, also sriving o sabilise producion and employmen around long-erm susainable pahs. The Riksbank herefore conducs wha is generally referred o as flexible inflaion argeing. Thus, he mandaes of he Federal Reserve and he Riksbank boh boil down o sabilizing inflaion around an inflaion arge and employmen around a long-run susainable rae. Furhermore, in siuaions when he labor-marke paricipaion rae is exogenous o moneary policy, sabilizing employmen around a long-run susainable rae is he same hing as sabilizing unemploymen around a long-run susainable unemploymen rae. 2 The relaive weigh on unemploymen gap sabilizaion Thus, under he assumpion ha he labor-marke paricipaion rae is exogenous, a mandae-consisen loss funcion for moneary policy can be wrien as he sandard quadraic loss funcion, L = (π π*) 2 + λ(u u*) 2, (1) where π and π * denoe he inflaion rae and he inflaion arge, respecively, u and u * denoe he unemploymen rae and he long-run susainable unemploymen rae, and λ is he weigh on unemploymen-gap sabilizaion relaive o ha on inflaiongap sabilizaion. Wha is he value of he relaive weigh, λ? My own view, so far, is ha a relaive weigh equal o one, ha is, equal weigh on sabilizing inflaion and unemploymen, 2 The employmen gap beween he rae of employmen and a long-run susainable rae of employmen equals he labor-marke paricipaion gap less he unemploymen gap, where he paricipaion gap is he gap beween he acual rae of labor-marke paricipaion and a long-run susainable rae. In Sweden, he paricipaion gap is currenly considered o be small and sable. For he U.S., Erceg and Levin (2013) argue ha he paricipaion gap is significan and endogenous and has fallen in response o he recession. Then he unemploymen gap needs o be adjused for he paricipaion gap in order o be consisen wih he employmen gap. 2

4 is appropriae. As discussed in Svensson (2013), he Riksbank has no been clear on he relaive weigh. The Federal Reserve has been more ransparen. Is reference o a balanced approach in FOMC (2012) indicaes ha he relaive weigh should no be far from one. Bernanke (2012) and Yellen (2012) refer o maximum employmen sanding on an equal fooing wih price sabiliy, reinforcing he view ha he relaive weigh is one or close o one. Evans (2012) has previously clarified ha his own relaive weigh is one, and discusses his in more deail in Evans (2014). 3 Wha inflaion and unemploymen gaps are opimal? Suppose he loss funcion is given by (1) and suppose ha here is a simple Phillips curve of he form π = π e γ(u!u ) +ε, (2) e where π denoes inflaion expecaions,!u denoes a shor-run naural rae of unemploymen (which in he shor-run may differ from he long-run susainable unemploymen rae u *), ε is an exogenous shock, and γ is a posiive consan. For a New Keynesian Phillips curve, he inflaion expecaions are expecaions in he curren period of fuure inflaion; for a New Classical Phillips curve, hey are lagged expecaions of curren inflaion. For opimizaion under discreion and a simple New Keynesian or New Classical model wih raional expecaions, he firs-order condiion for he cenral bank can be wrien λ π π* = ( u u*). (3) γ Wih near raional and sicky inflaion expecaions ha are anchored a he inflaion arge (Svensson 2014b), he firs-order condiion for he cenral bank can also be approximaed as (3). This sugges an approximae forecas argeing rule, λ π+ τ, π* = ( u+ τ, u*), τ 0, (4) γ 3 As Evans (2012, 2014), clarifies ha, if he Okun coefficien is wo, so a one-percenage-poin increase in unemploymen is associaed wih a wo-percen fall in oupu, a relaive weigh on unemploymen-gap sabilizaion equal o one corresponds o a relaive weigh on oupu-gap sabilizaion equal o

5 where π and + τ, u + τ denoe he forecas in period for inflaion and unemploymen, in period + τ for τ 0. If he unemploymen forecas is above (below) he long-run susainable rae, he inflaion forecas should be above (below) inflaion arge. Thus, he forecas of he unemploymen gap should normally have he same sign as he forecas of he inflaion gap; a varian of he so-called Qvigsad rule, of he former Norges Bank Depuy Governor Jan Qvigsad (2005). Thus, according o his, he cenral bank should le inflaion overshoo he arge, when he unemploymen forecas is above a long-run susainable rae. Furhermore, esimaes of Phillips curves indicae ha he slope, γ, is less han one (Fuhrer 2011, IMF 2013, Svensson 2014b). Wih λ equal o one, his means ha he coefficien λ / γ in (3) and (4) is larger han one. Tha means ha forecased inflaion gap forecas should be larger han he forecased unemploymen gap, π π* > u u*, τ 0. (5) + τ, + τ, Wih a more complicaed model, he firs-order condiion is more complicaed. Sill, he resul ha opimal policy when unemploymen is above a long-run susainable rae involves inflaion overshooing he arge is very inuiive. Yellen (2012) provides simulaions wih he model FRB/US of opimal policy for he Federal Reserve, where inflaion overshoos he arge. Kocherlakoa (2014) also emphasizes his propery of opimal policy. Conclusion I have compared he mandaes of he Federal Reserve and he Riksbank and concluded ha hey are for pracical purposes he same. They boil down o sabilizing inflaion around he inflaion arge and employmen around a long-run susainable rae. When he labor-marke paricipaion rae is exogenous o moneary policy, sabilizing employmen around a long-run susainable rae is he same as sabilizing unemploymen around a long-run susainable rae. The Federal Reserve s saemen on longer-run goals and moneary-policy sraegy, in paricular he wording abou a balance approach, may be inerpreed as he relaive weigh on employmen and unemploymen sabilizaion no very far from one. Saemens from several FOMC paricipans suppors his inerpreaion. 4

6 For a quadraic loss funcion and a simple Phillips curve, a firs-order condiion for he cenral bank suggess an approximae forecas argeing rule, such ha he forecas of he inflaion gap should have he same sign as and be proporional o he forecas of he unemploymen gap. Furhermore, wih a relaive weigh on unemploymen sabilizaion equal o one and esimaed slopes of Phillips curves less han one, an opimal inflaion gap may need o be larger han he unemploymen gap. Inflaion overshooing he arge, when he unemploymen gap is posiive, is no, however, wha we have seen in a number of counries since he financial crisis. In he U.S., inflaion has been low a he same ime ha unemploymen has been high. On he oher hand, he Federal Reserve is facing a binding lower bound for he policy rae and has used forward guidance and balance-shee policies exensively in order o implemen a more expansionary moneary policy. The U.K. is an excepion, where inflaion has oversho he arge subsanially excep very recenly (Miles 2014). Sweden is, unforunaely, an exreme example. Unemploymen is high, far above a reasonable long-run susainable rae. CPI inflaion is very low, far below he arge of 2 percen, abou zero during he las few years, and negaive during he firs hree monhs of Furhermore, his is arguably he resul of a dramaic and misaken policy ighening in he summer of 2010, ogeher wih a relucance o laer loosen policy, as furher discussed in Svensson (2011, 2013, 2014a). 5

7 References Bernanke, Ben S. (2012) Transcrip of Chairman Bernanke s Press Conference, January 25, 2012, Erceg, Chrisopher J., and Andrew T. Levin. (2014) Labor Force Paricipaion and Moneary Policy in he Wake of he Grea Recession, his issue. Evans, Charles L. (2012) Moneary Policy Communicaions and Forward Guidance, speech a he Inernaional Research Forum on Moneary Policy Sevenh Conference, Frankfur am Main, March 16, 2012, Evans, Charles L. (2014) Mainsream Economic Analysis and he Case for Accomodaion, his issue. FOMC. (2014) Saemen on Longer-Run Goals and Moneary Policy Sraegy, January 28, 2014, Fuhrer, Jeffrey C. (2011) Inflaion Expecaions and he Evoluion of U.S. Inflaion, Public Policy Brief No. 11-4, Federal Reserve Bank of Boson, IMF. (2013) The Dog Tha Didn Bark: Has Inflaion Been Muzzled or Was I Jus Sleeping? World Economic Oulook, April 2013, chap. 3, Kocherlakoa, Narayana. (2014) Achieving he Dual Mandae, Togeher: Designing Effecive, Appropriae Policy o Balance Price Sabiliy and Maximum Employmen, Ninh Disric Noes, June 2013, Federal Reserve Bank of Minneapolis, Miles, David. (2014) Inflaion, Employmen and Moneary Policy: Objecives and Oucomes in he UK and he US Compared, his issue. Qvigsad, Jan F. (2005) When does an ineres rae pah look good? Crieria for an appropriae fuure ineres rae pah - A pracician s approach, Saff Memo No. 2005/6, Norges Bank, Svensson, Lars E.O. (2011) Pracical Moneary Policy: Examples from Sweden and he Unied Saes, Brookings Papers on Economic Aciviy, Fall 2011,

8 Svensson, Lars E.O. (2013) Some Lessons from Six Years of Pracical Inflaion Targeing, Sveriges Riksbank Economic Review 2013:3, 29-80, larseosvensson.se. Svensson, Lars E.O. (2014a) Deflaion: Quesions and Answers, blog pos, April 14, 2014, larseosvensson.se. Svensson, Lars E.O. (2014b) The Possible Unemploymen Cos of Average Inflaion below a Credible Targe, American Economic Journal: Macroeconomics, forhcoming. Yellen, Jane L. (2012) Revoluion and Evoluion in Cenral Bank Communicaions, speech a he Haas School of Business, Berkeley, November 13, 7

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