Indeed, the FOMC discussed this issue at great length (see the minutes of our January 2011 meeting).4 However, I have yet to see empirical evidence based on a modeling framework that successfully captures U.S. business cycle dynamics that shows such supply-side structural factors can come close to explaining the huge shortfalls in actual GDP from trend and the high level of unemployment. For example, extended unemployment insurance and increased difficulties in matching workers to vacant jobs may have resulted in a transitory increase in the natural rate of unemployment, but the analysis I’ve seen doesn’t get you close to the 9 percent rate we currently are experiencing. The policy loss function The macroeconomics literature often describes the policymaker’s problem as one of minimizing societal costs of bad outcomes – which it mathematically approximates by the sum of the squared deviations in inflation from its target and the unemployment rate from its so-called natural rate. It turns out that a conservative and tough-minded central banker should value these deviations about equally.5 Accordingly, an inflation rate of 5 percent against an inflation goal of 2 percent is the same sized loss as an unemployment rate of 9 percent against a conservative estimate of 6 percent for the natural rate of unemployment. Today, we are facing an unemployment rate of 9 percent with little prospect of meaningful declines soon and the medium-term outlook for inflation is under 2 percent. This policy framework is often described as flexible inflation targeting.
In my mind, the Federal Reserve Act is very clear in specifying that the Federal Reserve has a dual mandate: The FOMC should provide for monetary and financial conditions that support maximum employment and price stability.2 With regard to inflation, we should seek to keep inflation near 2 percent over the medium term. We should also remember that a 2 percent objective should represent an average level of inflation, not an impenetrable ceiling. With regard to our real economy mandate, we should minimize the deviations of the actual path of the real economy from its potential path (or more technically, its efficiently-achievable path). From my earlier discussion of the immensity of the current problem, we are far from minimizing these real deviations today. Second, the FOMC needs to closely look at the plethora of data that comes out every month in order to evaluate the outlook for the economy and inflation, keeping in mind a variety of potential risk scenarios and financial stability considerations. Four times each year, the FOMC formally publishes forecasts in its Summary of Economic Projections. Of course, it is crucial for each FOMC member to update his/her outlook for each meeting. Third, in evaluating the state of the economy and inflation pressures, the FOMC must periodically step back and ask itself whether something very different than normal is afoot. We all recognize that our views about how the economy works are imperfect.