Scott Sumner has a recent post regarding an article that appeared in Reuters about Janet Yellen’s musings regarding whether the Great Recession has left permanent scars on the supply side and the US labor market.

Here is an excerpt of Reuters‘ characterization of Yellen’s remarks:

 The Federal Reserve may need to run a “high-pressure economy” to reverse damage from the 2008-2009 crisis that depressed output, sidelined workers, and risks becoming a permanent scar, Fed Chair Janet Yellen said on Friday in a broad review of where the recovery may still fall short.

Though not addressing interest rates or immediate policy concerns directly, Yellen laid out the deepening concern at the Fed that U.S. economic potential is slipping and aggressive steps may be needed to rebuild it.

I had read the article when it was published on Friday, prior to the Sumner post, and I got something entirely different from it. Perhaps part of misunderstanding has to do with the fact that this article has very few direct quotes in it, and is mostly a characterization of the Yellen’s speech, thus subject to the comprehension of the author. I’d like to note that the word “potential” isn’t enclosed in quotes.

I do not know what Yellen said nor what she meant in her speech. I can’t tell from the article. To me, it sounded like a possibility that she is starting to come around to the point of view that Bernanke’s tight money legacy doesn’t match the hype. This is the best news I’ve heard coming out of the Fed in quite a long time because of the following points:

  • Money is “neutral.” I used quotes on the word “neutral” here because there’s a difference between a one-time change in the base, and ongoing changes in the base; and we have been living under a regime of expectations management that promises tighter money as an ongoing policy, so I use the phrase “changes in the base” loosely.
  • My narrative of the Great Recession is that we had, with perhaps the exception of during the QE3 program, an ongoing condition of tight money. And what I mean by that, is that the NGDP trend was pulled down by several trillion in 2009 and has been pretty stable since; 1Q 16 was about $100B above (from my chart made with FRED NGDP data). Circling back around to point one, that new, lower NGDP trend that began in 2009 either completely refutes the theory that money is “neutral”, or there is a black hole floating somewhere around the Federal Reserve building, sucking up everything green. I tend to believe the latter, though I am certain it is not a naturally occurring phenomenon.
  • So in 2008-9, we have this monetary shock event, an event so big it turned cities into ghost towns virtually overnight with very little of effect having been done about it until late 2012, all the while Fed Officials were talking up the import of credibility on inflation (bizarre). One of the first comments I ever made on the Market Monetarist was about the damage being done by Fed officials who were publically tough on inflation in 2011 as we watched markets crash a little each time, and by then, this had been an ongoing occurrence.
  • It is my point of view, and I could very well be wrong, that there is an opportunity cost to this kind of tight money policy, in the fashion of an asymmetrical 2% inflation ceiling – it is necessary to keep the economy from reaching potential in order to prevent a breech – a policy I believe is far from optimal in many ways.

Now, why would I be worried about Yellen perhaps expressing the view that Fed policy has wrought some degree of ongoing economic damage with asymmetrical inflation targeting when I profoundly agree with that assessment? Heck, I am swinging from the rafters with glee about now, and she certainly has my complete attention!

This is what Sumner has said about the article:

I see this as a big mistake. The Fed needs to focus on smoothing out the path of nominal spending.  There’s not much they can do about the economy’s “potential”, and trying to boost it would end up destabilizing the economy.  Back in the 1960s, the Fed also believed there was a permanent trade-off between inflation and unemployment—it did not end well.

It would be destabilizing to let inflation go to 3% while unemployment is low.  It would bring the recovery to a premature end, triggering another recession as soon as the economy was hit by another oil shock.  Instead, the Fed should shoot for 3% inflation during the next recession—not during this expansion.  But they currently lack a policy regime capable of achieving that (countercyclical) outcome.  Yellen’s policy remains resolutely procyclical.  NGDPLT anyone?

Perhaps Sumner was in a hurry when he wrote this post, because there is a lot with which to quibble that I see here.

If the current policy is to manage demand in such a manner as to prevent the economy from reaching potential, intending to leave enough slack as to prevent a breach of the 2% inflation ceiling, and by all accounts certainly overachieving in that area, then there is an addressable problem regarding potential. What I think Yellen may have said is that potential is not necessarily granted, and when possibilities aren’t realized over a period of time, they may vanish. So sad that it is the reality of denial.

This part, “It would be destabilizing to let inflation go to 3% while unemployment is low, “and what follows I am chalking up to a poor choice of words. I simply do not understand it in any context and it should be clarified. After the Volker recession, for the remainder of his tenure, inflation ran higher than 3%, and I am not aware of anyone claiming Volker destabilized the economy and caused a recession with the horrors of 3% plus inflation. And if the Fed were smoothing trend NGDP, inflation may very well run at 3% from time to time, depending on supply side circumstances and it doesn’t matter, or so the argument goes. 3% is better than higher unemployment for the sake of an arbitrary inflation target, or maybe those investors will just go bat-shit crazy and we’d just end up with too many Amazon.coms… This is a ridiculous point.