Additional challenge #1: Reinhart and Rogoff’s great contraction and debt overhang The Financial Crisis of 2008 left an enormous obstacle in the path of the U.S. recovery. From peak to trough, $ trillion of wealth was erased from household balance sheets. Although the value of households’ assets declined dramatically, their debt levels remained roughly the same. Many borrowers took on additional debt during the period of high and rising asset valuations, and high employment and income growth were key fundamentals for servicing these debt payments into the future. These debt burdens are key contributors to the headwinds I discussed earlier when I talked about the economic outlook. As I noted then, they appear to be substantially more onerous than we had expected. In their book This Time is Different, Carmen Reinhart and Ken Rogoff documented the substantially more detrimental effects that financial crises typically impose on economic recoveries.7 Recoveries following severe financial crises take many years longer than usual, and the risk of a second recession before the ultimate economic recovery returns to the previous business cycle peak is substantially higher. In a related study of the current U.S. experience, Reinhart and Rogoff show that the current anemic recovery is following the typical post-financial crisis path quite closely, given the size of the financial contraction.8 It would be nice to point to some features of the recovery that suggest greater progress relative to the Reinhart-Rogoff benchmark. But those are hard to come by.
Making this translation in the loss function, we see that the conservative central banker attempts to minimize the equally weighted sum of squared inflation and unemployment deviations: L = (π – π*)2 + 1 * (u – u*)2 where u and u* are the actual and natural rates of unemployment6 The bottom line is that a conservative and tough-minded central banker can still value deviations in unemployment from the natural rate equally with deviations in inflation from its target. Accordingly, an inflation rate of 5% against an inflation goal of 2% presents this  3  Taylor, John B. 1979. “Estimation and Control of a Macroeconomic Model with Rational Expectations,” Econometrica 47 (5) September, pp. 1267–1286. 4  For example, Woodford, Michael, 2005. “Central-Bank Communication and Policy Effectiveness,” Paper presented at Federal Reserve Bank of Kansas City Symposium on “The Greenspan Era: Lessons for the Future,” Jackson Hole, Wyoming, August 25–27, 2005. Available at: http://www.columbia.edu/~mw2230/JHole05.pdf  5  Rogoff, Kenneth S. 1985. “The Optimal Degree of Commitment to an Intermediate Monetary Target,” Quarterly Journal of Economics 100 November, pp. 1169–1189. 6  That is, Okuns’ Law says (y – y*) = 2*(u – u*), where u and u* are the actual and natural rates of unemployment. Making this translation in the loss function (so squaring and multiplying by ? = ¼ yields L = (? – ? *)2 + 1 * (u – u*)2.