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Meyer's Head

JACKSON HOLE, Wyo. -- It may not seem like it, but what appears below is a condensed version of the

speech that




delivered yesterday. I think Meyer is far and away the straightest-shooting policymaker of the bunch, so most of this is just direct quotes; this piece's information-to-analysis ratio is huge. Skip it entirely if you ain't into that.

The fundamental question today, it seems to me, is whether the current set of macroeconomic conditions -- specifically, the growth of output and the unemployment rate -- is sustainable -- that is, consistent with stable, low inflation. If it is, the expansion could continue on its current path, unless disturbed by some shock or policy mistake. Otherwise, the challenge for monetary policy is to guide the economy to a sustainable path while preserving low inflation.

Does the big growth rate/low unemployment rate combo we see now threaten the inflation outlook? That's the Big Question.

There exist four varieties of landings.

(a) A soft landing.

A soft landing occurs if, as the level of output approaches potential, the growth of actual output slows to the growth of potential output just as actual output reaches potential. ... Ultimately, inflation dynamics will be driven by the output gap. At some point in any expansion, therefore, a soft landing is the preferred path to preserve a healthy expansion.

A soft landing is the preferred course to ensuring a healthy, sustainable expansion, if it can be executed.

(b) A reverse soft landing.

Above-trend growth in the expansion phase has moved the economy beyond the point of its sustainable capacity to produce. Policymakers in this case failed to execute a soft landing. ... In this case, because the economy is already operating beyond its sustainable capacity, the economy may not be able to avoid some acceleration in inflation as policymakers try to engineer the soft landing. Therefore, the return to the potential output path has to be achieved in a sufficiently timely fashion to minimize any increase in inflation during the transition. Also, in the reverse soft landing case, growth must slow, not just to trend but to below trend in order to close the output gap.

A reverse soft landing is the second-best option.

(c) The best-case scenario: supply meets demand.

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The growth of potential increases just as output threatens to push beyond potential. ... If this scenario describes the current episode, then the economy can continue to grow at 4%, the unemployment rate can remain near 4%, and inflation can remain steady at its prevailing rate.

We should not expect a perfect balancing between supply and demand.

(d) The worst-case scenario: hard landings.

Above-trend output growth during the expansion ultimately pushes output well beyond potential for a persistent period. The resulting overheating puts upward pressure on inflation. The monetary policy response to reverse the inflation often yields a decline in output. ... This is the scenario from which we draw the lesson that timely, typically preemptive, policy restraint to avoid the excesses of a boom results in longer expansions and avoids unnecessary fluctuations in both output and inflation.

Looking back, most recessions have resulted from attempts by the policy authorities -- yes, the Fed -- to reverse increases in inflation generated by overheating.

That last sentence is easily (in my view) the most striking one in the entire speech: A central banker saying that yes, the Fed is far and away the No. 1 cause of recessions.


Cause it ends up having to jack up rates to "reverse increases in inflation."


Cause it remains too accommodative for too long -- and that's what produces the overheating to begin with.

Inflation is above all else a money thing, and policymakers are the ones who do the pumping.

There is a consensus that the NAIRU the non-accelerating inflation rate of unemployment has declined since the early 1990s. ... There is also a consensus that the rate of growth of potential output is higher today than during the twenty years preceding this expansion. However, the degree to which these two parameters have changed is not a settled issue. ... Various estimates of the NAIRU and trend growth, drawn from researchers, model-based forecasts, assumptions incorporated in government budget projections, and surveys of economic forecasters ... suggest that actual output is above potential (the unemployment rate is below the NAIRU) and that actual output growth has been above trend growth of potential.

Even after we incorporate the estimated decline in the NAIRU and the higher rate of growth of potential, output is above potential and output growth exceeds that of potential.

Meyer sees (b) and (d) as our landing possibilities.

Much of the recent concern about the sustainability of this expansion is not related directly to the balance between aggregate demand and aggregate supply. ... Concerns have also been raised about potential imbalances in some sectors, for example, about the sustainability of equity prices, the personal saving rate, the current account deficit, and debt burdens.

This speaks to hard landings associated with the unwinding of sector and market imbalances.

The current price-to-earnings ratio of about 32 for the S&P 500 index, based on the trailing four-quarter earnings, compares with an average of 16 since 1957 and a high before this expansion of 22.3 in August 1987. ... The personal saving rate has declined in this episode to a record low. The current account balance, measured as the ratio to nominal gross domestic product (GDP), has also declined to a record low. ... The ratio of debt service costs to disposable income for the household sector, a preferred measure of the household debt burden, has been rising since the mid-1990s but remains below the peak reached in the mid-1980s.

But this cyclical expansion is not ordinary. It is exceptional. ... It is therefore not surprising that cyclically sensitive variables are behaving exceptionally by historical standards.

None of the four things mentioned above definitively demonstrate that there is an unsustainable imbalance; they show why some folks have worried that there might be.

The two types of imbalances -- an imbalance between aggregate demand and aggregate supply and sector or market imbalances -- could be connected. Consider a situation in which growth is above trend and output moves beyond capacity. If investors misread these developments as sustainable and, therefore, extrapolate the exceptional conditions, exceptional and perhaps unsustainable movements in equity prices, the saving rate, and debt burden might be encouraged. Alternatively, a rise in equity prices that outstrips fundamentals might contribute to a pace of private domestic demand that ultimately takes output beyond capacity; in this case, the market or sector imbalance would be what contributed to the aggregate demand-supply imbalance.

This analysis leaves us with four possible combinations.

(i) Simultaneous imbalances in both aggregate demand/supply and market/sector variables.

(ii) Simultaneous balance in each class.

(iii) Aggregate demand/supply imbalance accompanied by balance in market/sector variables.

(iv) Aggregate demand/supply balance accompanied by market/sector imbalances.

The most important of the perceived imbalances I have discussed today is, in my view, the possibility of an overheated economy. ... My guess is that if we avoid the boom-bust scenario, we shall have avoided the most serious of the other imbalances or at least will be in a better position to absorb and respond to the unwinding of other possible imbalances. ... Policymakers will, I expect, be reluctant to undermine macroeconomic performance in the short run in an attempt to unwind a perceived market/sector imbalance that might not be serious or might unwind in a gradual and nondisruptive fashion on its own. ... As a result, monetary policy, in my view, needs to focus on achieving balance between aggregate supply and aggregate demand.

This much is clear: The guy is aiming for (b) but hardly ruling out (d). As such, for as long as current growth rates and unemployment levels persist, it is hard to believe he won't be arguing for policy action aggressive enough to prevent the overheating that an overly accommodative central bank invariably produces.

He is, after all, well aware of the sorry record of his predecessors.