The 5 x 5 Plan For Monetary Recovery

U.S. Federal Reserve Board Chairman Ben Bernanke

Photograph by Karen Bleier/AFP/Getty Images.

Paul Krugman is not exactly known for his sunny optimism, so I think it’s notable that as of his latest column he seems to be on the Recovery Winter bandwagon. The point here isn’t that anything particularly wonderful happened last fall or this winter to spur recovery, but that even your great-grandfather’s depressions ended despite a lack of any meaningful policy response.

One dour note I will bring to the party is this: Your great-grandfather’s recessions weren’t met with adequate counter-cyclical policy response and so they tended to drag on for a painfully long time. But by the same token, once recovery was under way you didn’t need to worry as much about new policy screwups. My belief that the economy is now on the road to recovery is contingent on the idea that policymakers don’t make any new blunders. But there are always x factors out there like the debt ceiling debacle, and in principle congressional brinksmanship over this or that could prompt a new round of hoarding behavior in the private sector. But more prosaically, there’s always monetary policy. Last year in both April and July the European Central Bank raised interest rates, having concluded that even the slightest whiff of consumer price inflation was an intolerable price to pay for economic recovery. And like magic they managed to plunge huge swathes of the continent into renewed bouts of crisis. The same thing could happen here. In a solid recovery jobs month, you’d expect three or four hundred thousand new commuters to take the road to enjoy the employed lifestyle. And to get back to full employment, we would need many months in a row of those hundreds of thousands of new commuters driving around. Gasoline might get more expensive. Rents might rise to spur new construction, and then keeping drifting upwards for a bit until new projects are finished. Health care spending might surge if incomes rise and people who’ve been delaying treatment finally go get those cholersterol checks. A recovery scenario would, in other words, present plenty of opportunities for panicky Fed officials to quash the recovery and there’s no shortage of inflation paranoia in the media to justify such a course of action.

It’s crucial that this doesn’t come to pass.

This is why one of the most helpful, but also most modest, steps the new Federal Reserve Open Market Committee could take would be to lay down some markers. Say: “we judge the natural rate of unemployment to be about such-and-such and therefore commit not to engage in any monetary tightening unless we get all the way down to the that level, but if core inflation rises above such-and-such percent we’ll conclude that we were too optimistic about the structure of the labor market and need to tighten anyway.” I’d advocate for pretty aggressive targets—something like 5 percent unemployment or 5 percent inflation. But even if they were to choose much more conservative targets than my 5 x 5 Plan it would help. The important think is to look squarely at the possibility of a temporary price spike as people head back to work, and say they intend to power through it.