The Problem With Unobservable Variables

Jul 2, 2018

Inflation has climbed above the Federal Reserve's target of 2 percent. According to the Personal Consumption Expenditures price index, the Fed's preferred inflation measure, prices climbed by 2.3 percent in the year through the end of May.

Price stability is one of the Fed's mandates. So should the Fed now act to bring inflation back down to 2 percent? There are reasons to think it shouldn't bother, at least not yet. For one thing, the variables pushing inflation higher might be temporary. Another reason is that inflation has been below the target for most of the recovery, so a period of inflation modestly above target shouldn't be much of a concern.

On the show, we speak with Sarah Bloom Raskin, formerly a governor on the Federal Reserve Board, who adds that the Fed needs to give just as much consideration to its second mandate, maximum employment. Although the unemployment rate is lower than the Fed's estimate for maximum employment, Raskin says that other indicators tell a different story.

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Let's say that a year ago, a pair of tickets to see your hometown baseball team play cost you a hundred dollars.


Oh, my God. Where's your hometown?


GARCIA: Hypothetical exercise, Stacey.

VANEK SMITH: I will say that the Boise Eagles - like, nowhere near a hundred dollars. Sorry. Please. Please continue.

GARCIA: So a hundred dollars a year ago to see the Boise Eagles. And this year, you want to go see the Boise Eagles again. And you know that things get a little bit more expensive over time. That's just regular inflation. So you figure that the tickets might be $102 instead.

So you go up to the ticket window on game day, and it turns out that the tickets actually are $102.30. Would you really care that much about the extra 30 cents? I'm guessing, no, that you're not really going to make too much of a fuss.

VANEK SMITH: I would be asking a lot of questions about the $102. No, the 30 cents would not be of huge concern. But that 30 cents is the difference between inflation of 2 percent and inflation of 2.3 percent, which seems like no big deal, like, you shouldn't really care. But, in fact, you should care.

GARCIA: Yes. Those are not entirely hypothetical numbers either. I mean, the Boise Eagles thing was definitely a nice touch.

VANEK SMITH: You're just blowing my mind.

GARCIA: We just learned that inflation in the past year was, in fact, 2.3 percent. That is today's Planet Money indicator, 2.3 percent. And the fact that inflation is now higher than 2 percent is important, not because the stuff you buy is a tad more expensive than you thought it was going to be, but because if inflation does not go back down, it might just lead the Federal Reserve to start slowing down the economy.

VANEK SMITH: Unless, that is, the Fed looks away and decides, we don't really care if inflation is a little high. Today on the show - why that might just be a good idea.


GARCIA: Since today's show is about a choice that the Federal Reserve has to make, we wanted to talk to someone who knows how this works firsthand.

SARAH BLOOM RASKIN: I am Sarah Bloom Raskin, and I was a Governor on the Federal Reserve Board from 2010 to 2014.

VANEK SMITH: As a Governor, Sarah was one of the people who voted on monetary policy decisions at the Fed. And one of the Fed's mandates is known as price stability, which means that the Fed tries to keep inflation growing at 2 percent a year. So from year to year, the average price of all the things you buy should grow by about 2 percent. That is the target - not much higher, and also not much lower - just stable.

So when inflation is too low, the Fed can try to boost the economy by lowering interest rates, which makes it cheaper for people to borrow money and spend it.

GARCIA: And when inflation is too high, the Fed tries to slow the economy by raising interest rates. And even though inflation is now at 2.3 percent, which is obviously higher than the target, Sarah is not too worried about inflation just yet. In other words, it's not yet clear that the Fed should try to halt the economy's progress just because inflation is above the target.

RASKIN: My own read, and again, it's going to change, you know, moment by moment, but that the inflation readings that we are seeing right now are due to transitory forces.

VANEK SMITH: Transitory forces. In other words, it could be temporary. For example, the price of oil has shot up in the past year, and that pushes the overall inflation number higher. But we know that the price of oil tends to be volatile. So there's a chance that it will stay flat now, or even start to fall, and that would drive inflation back down.

GARCIA: Now the Fed's second mandate, other than price stability, is known as maximum employment.

VANEK SMITH: And here's what that means. When the Fed stimulates the economy and the economy becomes really strong, companies hire more workers, and the unemployment rate goes down.

But there comes a point when so many workers have been hired that the only way a company can hire new workers is to raise wages and salaries for those workers much higher. And when workers have higher salaries, they also have more money to spend, and that pushes up inflation. There's just more money around in the economy.

GARCIA: Yeah, exactly. Maximum employment is the sweet spot. That's when the economy is at the point where the labor market is so strong that if it gets any stronger, then inflation might shoot up, maybe even way above that 2 percent target.

VANEK SMITH: And the question facing the Fed now is, how do we know when unemployment has gone too low - so low that high inflation might become a problem? Put another way, how do we know when the economy is at maximum employment?

The Fed only has a way of guessing the answer. It tries to estimate something known as the natural rate of unemployment. If unemployment falls below this level, inflation might start shooting up.

GARCIA: Yeah. Here's the thing, though. The Fed's estimate for the natural rate of unemployment is 4 1/2 percent. But unemployment now - right now - is already down to 3.8 percent. It's below that natural rate estimate. In fact, the actual unemployment rate has been below the Fed's estimate for the natural rate of unemployment for almost two years.

So by the Fed's own estimates, we are already past maximum employment. The unemployment rate is already low enough that we should've seen spiking inflation a while ago. Instead, inflation has been lower than the Fed's 2 percent target until just the last couple of months. And even then, as Sarah said, it seems plausible that it's only above 2 percent for temporary reasons.

VANEK SMITH: In fact, Fed Chair Jerome Powell was asked about this at his last press conference. And here's what he said.


JEROME POWELL: No one really knows with certainty what the level of the natural rate of unemployment is. We can't be too attached to these unobservable variables.

GARCIA: Unobservable variables.

VANEK SMITH: (Laughter).

GARCIA: He referred to the natural rate of unemployment, which the Fed itself tries to estimate, as an unobservable variable. It was kind of amazing to hear this from a Fed chair. The trade-off between inflation and unemployment is the basis on which monetary policy is made. And here's the chair himself saying that it's just really hard to know where that trade-off actually begins.

VANEK SMITH: I think I'm going to start using unobservable variables anytime anyone questions anything I do. I'll just be like, listen; the unobservable variable.

GARCIA: Can't base my decisions on unobservable variables.

VANEK SMITH: (Laughter).

GARCIA: I'm sorry. We asked Sarah what she thought of Chair Powell's comments.

RASKIN: I think he got it right. I think what, you know, another way to communicate the idea that the long-run sustainable rate is, in essence, just a guess.

VANEK SMITH: What Sarah is saying is that the unemployment rate is not enough to tell us whether the economy is at maximum employment. For that, we need to look at other measures. And unlike the unemployment rate, those other measures suggest that maybe the economy is not at maximum employment yet.

RASKIN: They're looking at, you know, what - how many people are working part-time but really want full-time jobs, how many people are discouraged and have stopped looking for jobs altogether, how many people are completely, you know, outside the labor force and are not counted at all in the traditional unemployment rate.

So there's a whole, you know, range of different labor market indicators. And I think, to some extent, he's implying in his answer, you know, let's not, you know, fetishize kind of one number here.

GARCIA: And the fact that those other measures that Sarah just mentioned don't point to an economy at maximum employment also matters for inflation. For the last seven years, inflation, on average, has been only 1.3 percent, which is clearly below the 2 percent target.

The fact that inflation only just recently went above the 2 percent target does not mean that the Fed has to immediately slow down the economy to bring inflation down right away. Fed Chair Powell might - just might - be signaling that he would tolerate inflation overshooting the target for a little while.

VANEK SMITH: Sarah says allowing inflation to overshoot for a little while before slowing down the economy could have a couple of advantages. The first is that we'll see if it was really just temporary factors that pushed it higher. But another advantage is that we will also find out how much stronger the labor market can become.

RASKIN: And so the real debates going on now have to do with whether there is more room for monetary policy to be attempting to drive unemployment lower. And you might say, well, wow, unemployment is already so low. Is there really - is there really much more room to go? And actually, there is.

And it's possible that with some more continued accommodation, it's argued that we can bring more people back into the labor force and be able to bring people into an ability to prosper.

GARCIA: This is not, by the way, just an abstract exercise. One of the themes at THE INDICATOR has been that there are categories of people who really struggle to get jobs, except when the labor market is so strong that employers have to consider hiring them - people with disabilities, people with criminal backgrounds, people with gaps in their resume. An economy pushing towards maximum employment means that they'll finally get a chance to enjoy the fruits of this recovery as well.


VANEK SMITH: I think it might be the Hawks. Now I'm worried it's the Hawks. Oh, I'm going to get so many letters. I'm so ashamed.

GARCIA: It's going to be awesome. It's going to be my favorite thing.

VANEK SMITH: It's the Hawks. It's the Boise Hawks.

GARCIA: (Laughter).

VANEK SMITH: I went to those games. What is wrong with me?