What Should the Fed Do? (Newspaper Column Version)

Finally, production is rising. Real Gross Domestic Product increased at a 3.5 percent annual rate in the third quarter. The real volume of consumer goods and services expanded 3.4 percent. Purchases of durable goods, including automobiles, expanded 22 percent. Nondurable goods, like food and clothing, expanded 2 percent, while services, like health care, expanded 1.2 percent.

The real volume of capital goods sold to business—machines, buildings, and equipment—decreased 2.5 percent. Most of that decrease was in industrial and commercial construction—9 percent. Equipment and software slightly increased, about one percent. Production of new homes increased 23 percent. The real volume of output absorbed by the federal government rose nearly 8 percent, but state and local government utilized 1.1 percent less. Some of the consumer and capital goods sold were produced in other countries—the real volume of imports expanded 17 percent. However, the real volume of exports, sales to foreigners, expanded nearly 15 percent.

While production is growing, it had fallen nearly 4 percent from its previous peak in the second quarter of 2008. Despite the increase last quarter, production remains 3 percent below that past peak. If production continues to expand at a 3.5 percent annual rate, it will take nearly a year to regain lost ground. Worse, the production of goods and services should have been rising all along, approximately 3 percent per year. Actual output is nearly 7 percent below productive capacity, according to C.B.O. estimates. Recovery at the current pace is so slow that closing the gap between actual output and the productive capacity of the economy will take years.

What about inflation? The annual rate of inflation in the third quarter, as measured by the GDP deflator, was slightly less than one percent. This modest increase in the price level masked a significant change in relative prices. Inflation was concentrated in nondurable consumer goods— 9.6 percent. Inflation in consumer services was only 1.6 percent. The prices of durable consumer goods fell 3 percent. Similarly, the prices of capital goods had 6 percent deflation and prices of new homes fell nearly 2 percent.

A rapid increase in prices combined with a modest increase in real volume suggests that the capacity to produce nondurable consumer good is limited. This points to malinvestment. Austrian economists Ludwig Von Mises and F.A. Hayek emphasized that productive capacity developed during a boom can be inconsistent with the preferences of consumers. C.B.O. estimates of productive capacity show slower growth over the past few years, falling from the usual 3 percent to 2.5 percent in 2005 and 2 percent last year. Perhaps this fails to fully account for the need to reallocate resources away from residential construction. While residential construction expanded last quarter, it remains nearly 53 percent below the peak reached in 2005.

Shifting resources to meet consumer demand requires producing the appropriate capital goods and moving workers between jobs. The structural unemployment associated with moving workers from where they are needed less to where they are needed more has always been both painful and persistent. A period of unusually slow growth in production and only gradual reductions in unemployment may be unavoidable.

However, low expenditures have exacerbated these problems. Total final sales of domestic product is nearly one percent below its peak in third quarter of 2008. Worse, the U.S. economy had adjusted to a 5 percent growth path of spending. Even if the past growth path of expenditures were adjusted to a 3 percent, noninflationary growth path, total spending is approximately 7 percent too low.

The Federal Reserve should commit to a target for $16.1 trillion for total final sales of domestic product for the fourth quarter 2010. That would require an 11 percent increase in nominal expenditures starting from third quarter 2009. Once total spending has returned to that growth path, future increases should be limited to a 3 percent growth rate—the rate consistent with long run price stability.

If the Fed increased the quantity of money enough for total expenditures to return to its previous growth path, what would happen to production and unemployment? It is likely that production would grow rapidly in response to increased expenditures and unemployment would fall dramatically. Unfortunately, a full recovery to the past trend for real output would be more gradual. Similarly, unemployment is likely to remain high, with gradual reductions in underlying structural unemployment allowing a return to an unemployment rate between 4 and 5 percent.

What would happen to inflation? The short run effect would be an increase in inflation. Productive capacity is limited in the industries producing what people want to buy now—apparently, nondurable consumer goods. Rising prices and profits in those industries will create incentives to expand productive capacity and employment. As resources are shifted and productive capacity adjusts to the new pattern of demand, not only will production expand and unemployment fall, prices of those goods will fall as well, reversing the temporary inflation.

Unfortunately, the Fed’s current policy is to commit to an extended period of low interest rates and a vague promise to so-called ”price stability,” a 2 percent annual increase in the CPI starting from wherever it happens to be. The Fed needs to commit to getting nominal expenditures back to a sensible growth path over the next year. The Fed should not try to keep adverse changes in productive capacity from causing temporary inflation. Nor should it prevent a deflation of prices as productive capacity recovers.

Finally, promising to keep interest rates at very low levels is a mistake. If the Fed commits to a rapid recovery of nominal expenditure, growing credit demand will rapidly increase market clearing interest rates. Promising to keep interest rates lower than dictated by market conditions is likely to lead to excessive inflation and even future malinvestment. While the Fed’s traditional policy appeared effective for over twenty years, the “Great Recession” proves that a new approach is needed.