Atlanta Fed President Dennis Lockhart is not ready to declare victory for the nation's economic recovery. He does, however, believe a turning point is at hand.
In his view, we are moving from an extraordinary economic period that called for unconventional monetary policy to a more normal environment for policy making. At an international conference of central bankers in Bern, Switzerland, on November 5, Lockhart detailed a framework that will guide his thinking about U.S. monetary policy "in its next phase."
Lockhart called this his "Taylor framework," referring to a well-known monetary policy rule devised by economist John Taylor. But unlike a fixed rule, this framework, Lockhart explained, does not lead to mechanically setting rates based on an inflexible formula. Rather, Lockhart said he will look to "rule-like benchmarks" based on judgments about three critical aspects of the economy:
- In general, the overall health of the labor market. In particular, he is closely tracking labor market slack, the gap between current and full use of labor resources. For now, Lockhart figures most, though not all, labor market slack is absorbed. So, in his view, we're almost there on jobs.
- The gap between actual inflation and the Fed's inflation target. Here, Lockhart's view is that inflation will gradually return to the Federal Open Market Committee's 2 percent target.
- The "neutral" real rate of interest, or an interest rate that should neither stimulate nor restrict economic activity. Based on a range of evidence, a reasonable estimate now would be a neutral rate of about zero, Lockhart said. He cautioned that any estimate based on complex and ambiguous variables like this one is subject to error and uncertainty.
Tracking the job market
Lockhart said he likes to observe the labor market through a "dashboard." His dashboard includes a new gauge from the Atlanta Fed. Along with workhorse measures including the official unemployment rate and the employment-to-population ratio, Lockhart monitors an indicator called the ZPOP ratio that was devised by Atlanta Fed economist John Robertson.
ZPOP, Lockhart said, is akin to a worker satisfaction ratio. Meant to gauge the portion of the population whose labor is fully used, the ZPOP estimates the share of the population that is working as much as they want. Specifically, ZPOP counts people as satisfied with their hours if they work full-time, work part-time by choice, or don't want a job.
The ZPOP ratio was 92 percent on a seasonally adjusted basis in September (see the chart). So by this statistic, 8 percent of the country's working-age population is underused. That level is well below the recent peak of 15 percent in early 2010, but just above the recent prerecession low of 7 percent in 2006.
The story ZPOP tells, then, aligns with the Atlanta Fed's view of the larger economy. "The conclusion our ZPOP-based analysis leads to is similar to our estimate of the output gap—that it's substantially, but not completely, closed," Lockhart said.
Views of inflation vary (or don't)
As the job market continues to gain ground, the inflation picture is perhaps hazier.
Fed policymakers pay close attention to where businesspeople, consumers and economists think inflation is headed. Inflation expectations are critical because they are a predictor of the economic behavior of consumers and businesses. Various surveys of those expectations have recently produced vastly different results, Lockhart noted. Professional economic forecasters tend to think inflation will move toward 2 percent, but consumer survey results are all over the map.
However, Atlanta Fed research suggests most of the differences in survey measures of inflation expectations result from the questions being asked. For instance, in Atlanta Fed surveys, business executives' answers vary greatly when they are asked about prices in general. But when the Reserve Bank asks businesspeople about costs they expect to face and prices they expect to charge, their answers generally line up with inflation expectations of professional economists, Lockhart said.
"Overall, it appears to me that inflation expectations are fairly well anchored," he said.
The final piece of the Taylor framework that Lockhart constructed is some measure of a "neutral" real interest rate. The neutral rate can serve as an important benchmark for policymakers to compare with the market rate. In theory, when interest rates are "neutral," the economy is on a sustainable path—just right.
That estimated neutral rate has been falling for some time and is at historically low levels, Lockhart noted. He views the low neutral rate as a product of fundamental forces beyond the reach of monetary policy, such as population aging, productivity growth, and the global appetite for saving and investment.
Important caveat
Useful as it is, the Taylor framework has its limits, Lockhart pointed out. "Any actual policy decision must take into account a broader array of considerations that cannot be captured by the simple framework I have described," he said.
For example, based on the framework alone, it would have been appropriate to raise the federal funds rate target at the September meeting of the Federal Open Market Committee, Lockhart said. "But emerging risks…called for some delay," he added. Those risks, including slowing growth in China and financial market volatility, are not fully captured in the Taylor framework.
"New risks or uncertainties may well color future decisions in a way that will justify continued deviations from the simple prescriptions of a Taylor framework," Lockhart concluded. "But it is apparent to me that we are in the midst of transition from an extraordinary period that called for unconventional tools, to a period where we again utilize rule-like benchmarks."
Charles Davidson
Staff writer for Economy Matters