Unemployment Can Get Even Lower

(Bloomberg Opinion) -- I have been arguing for some time that the Federal Reserve should run the U.S. economy “hot” by keeping interest rates low even after unemployment falls below its so-called natural rate. Not everyone agrees with me, to put it mildly. One of the more thoughtful critiques came this week from Raphael Bostic, president of the Atlanta Fed.

In a speech to a business group in Louisiana, Bostic defended the Fed’s policy of raising rates to help prevent a recession. As evidence, he presented a version of the chart below, which he called “a picture worth thinking about.”

Unemployment Can Get Even Lower
The areas in red — where the actual unemployment rate is lower than the natural rate — are what Bostic called “high-pressure periods.” Such periods, he noted, are always followed by a recession. That’s because the economy accumulates inefficiencies and misdirected investment during these periods, waste that subsequently has to be purged by a recession. Therefore, Bostic suggested, the Fed should continue to raise rates in an effort to forestall the high-pressure period that seems to building today.
There are many reasons to be skeptical of this line of reasoning, but the most obvious can be seen in Bostic’s own chart. The most intense periods of high pressure — those which lasted the longest and with the lowest unemployment — were followed by the mildest recessions.
Indeed, the biggest high-pressure period is during the late 1960s. During the recession that followed, unemployment barely rose above the Congressional Budget Office’s estimate of the long-run natural rate — precisely where Bostic’s analysis suggested it should have been all along.
I might also note that the late 1960s also saw dramatic improvements in economic opportunities for women and African-Americans, precisely the effect one would expect. (To his credit, Bostic conceded that such periods of exceptionally low unemployment can be helpful for minorities, women and younger workers, but argued that the costs outweigh the benefits.) Likewise, the highest rate of unemployment on Bostic’s chart occurred during the so-called “double-dip” recessions of the early 1980s.
It’s extremely difficult to reconcile Bostic’s explanation with the reality of the unemployment rate in the 1980s. The much more likely explanation, which Bostic barely mentions, is that the recessions of the 1980s were caused by the Fed raising interest rates.
It’s certainly true that running a high-pressure economy for too long can lead to higher inflation. That’s what happened in the 1970s. But this is not the 1970s. Inflation is low, and indeed has been below the Fed’s target rate for nearly a decade. In this environment, a high-pressure economy — that is, a hot economy — is a blessing that will improve the fortunes of the most disadvantaged workers.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a senior fellow at the Niskanen Center and founder of the blog Modeled Behavior.

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