Janet Yellen: Macroeconomic research after the crisis
Speech by Ms Janet L Yellen, Chair of the Board of Governors of the Federal Reserve System, at
"The Elusive 'Great' Recovery: Causes and Implications for Future Business Cycle Dynamics"
60th annual economic conference sponsored by the Federal Reserve Bank of Boston, Boston,
Massachusetts, 14 October 2016.
* * *
Watch live: www.bostonfed.org/live
Extreme economic events have often challenged existing views of how the economy works and
exposed shortcomings in the collective knowledge of economists. To give two well-known
examples, both the Great Depression and the stagflation of the 1970s motivated new ways of
thinking about economic phenomena. More recently, the financial crisis and its aftermath might
well prove to be a similar sort of turning point. Today I would like to reflect on some ways in which
the events of the past few years have revealed limits in economists' understanding of the
economy and suggest several important questions I hope the profession will try to answer. Some
of these questions are not new, though recent events have made them more urgent.
Appropriately, some are addressed by the papers prepared for this conference. Pursuing
answers to these questions is vital to the work of Federal Reserve and other economic
policymakers, and the Fed is likewise engaged in ongoing research to seek answers.
The Influence of Demand on Aggregate Supply
The first question I would like to pose concerns the distinction between aggregate supply and
aggregate demand: Are there circumstances in which changes in aggregate demand can have
an appreciable, persistent effect on aggregate supply?
Prior to the Great Recession, most economists would probably have answered this question with
a qualified "no." They would have broadly agreed with Robert Solow that economic output over
the longer term is primarily driven by supply-the amount of output of goods and services the
economy is capable of producing, given its labor and capital resources and existing technologies.
Aggregate demand, in contrast, was seen as explaining shorter-term fluctuations around the
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mostly exogenous supply-determined longer-run trend. This conclusion deserves to be
reconsidered in light of the failure of the level of economic activity to return to its pre-recession
trend in most advanced economies. This post-crisis experience suggests that changes in
aggregate demand may have an appreciable, persistent effect on aggregate supply-that is, on
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potential output.
The idea that persistent shortfalls in aggregate demand could adversely affect the supply side of
the economy-an effect commonly referred to as hysteresis-is not new; for example, the
possibility was discussed back in the mid-1980s with regard to the performance of European
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labor markets. But interest in the topic has increased in light of the persistent slowdown in
economic growth seen in many developed economies since the crisis. Several recent studies
present cross-country evidence indicating that severe and persistent recessions have historically
had these sorts of long-term effects, even for downturns that appear to have resulted largely or
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entirely from a shock to aggregate demand. With regard to the U.S. experience, one study
estimates that the level of potential output is now 7 percent below what would have been
expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is
attributable to several developments that likely occurred as a result of the deep recession and
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slow recovery. In particular, the study finds that in the wake of the crisis, the United States
experienced a modest reduction in labor supply as a result of reduced immigration and a fall in
labor force participation beyond what can be explained by cyclical conditions and demographic
factors, as well as a marked slowdown in the estimated trend growth rate of labor productivity.
The latter likely reflects an unusually slow pace of business capital accumulation since the crisis
and, more conjecturally, the sharp decline in spending on research and development and the
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very slow pace of new firm formation in recent years.
If we assume that hysteresis is in fact present to some degree after deep recessions, the natural
next question is to ask whether it might be possible to reverse these adverse supply-side effects
by temporarily running a "high-pressure economy," with robust aggregate demand and a tight
labor market. One can certainly identify plausible ways in which this might occur. Increased
business sales would almost certainly raise the productive capacity of the economy by
encouraging additional capital spending, especially if accompanied by reduced uncertainty about
future prospects. In addition, a tight labor market might draw in potential workers who would
otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to
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moreefficient-and, hence, more-productive-job matches. Finally, albeit more speculatively, strong
demand could potentially yield significant productivity gains by, among other things, prompting
higher levels of research and development spending and increasing the incentives to start new,
innovative businesses.
Hysteresis effects-and the possibility they might be reversed-could have important
implications for the conduct of monetary and fiscal policy. For example, hysteresis would seem
to make it even more important for policymakers to act quickly and aggressively in response to a
recession, because doing so would help to reduce the depth and persistence of the downturn,
thereby limiting the supply-side damage that might otherwise ensue. In addition, if strong
economic conditions can partially reverse supply-side damage after it has occurred, then
policymakers may want to aim at being more accommodative during recoveries than would be
called for under the traditional view that supply is largely independent of demand.
More research is needed, however, to better understand the influence of movements in
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aggregate demand on aggregate supply. From a policy perspective, we of course need to bear
in mind that an accommodative monetary stance, if maintained too long, could have costs that
exceed the benefits by increasing the risk of financial instability or undermining price stability.
More generally, the benefits and potential costs of pursuing such a strategy remain hard to
quantify, and other policies might be better suited to address damage to the supply side of the
economy.
Heterogeneity
My second question asks whether individual differences within broad groups of actors in the
economy can influence aggregate economic outcomes-in particular, what effect does such
heterogeneity have on aggregate demand?
Many macroeconomists work with models where groups of individual actors, such as
households or firms, are treated as a single "representative" agent whose behavior stands in for
that of the group as a whole. For example, rather than explicitly modeling and then adding up the
separate actions of a large number of different households, a macro model might instead
assume that the behavior of a single "average" household can describe the aggregate behavior
of all households.
Prior to the financial crisis, these so-called representative-agent models were the dominant
paradigm for analyzing many macroeconomic questions. However, a disaggregated approach
seems needed to understand some key aspects of the Great Recession. To give one example,
consider the effects of negative housing equity on consumption. Although households typically
reduce their spending in response to wealth declines, the many households whose equity
positions in their homes were actually drivennegative by the reduction in house prices may have
curtailed their spending even more sharply because of a markedly reduced ability to borrow.
Such a development, in turn, would shift the relationship between housing equity (which
remained solidly positive in the aggregate) and consumer spending for the economy as a whole.
Such a shift in an aggregate relationship would be difficult to understand or predict without using
disaggregated data and models.
More generally, studying the effects of household and firm heterogeneity might help us better
account for the severity of the recession and the slow recovery. At the household level, recent
research finds that heterogeneity can amplify the effects of adverse shocks, a result that is
largely driven by households with very little net worth that sharply increase their savings in a
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recession. At the firm level, there is evidence that financial constraints had a particularly large
adverse effect on employment at small firms and the start-up of new firms, factors that may be
part of the explanation for the Great Recession's long duration and the subsequent slow
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recovery. More generally, if larger firms seeking to expand have better access to credit than
smaller ones, overall growth in investment and employment could depend in part on the
distribution of sales across different types of businesses. Modeling any of these issues
quantitatively will likely require the use of a heterogeneous-agent framework.
Economists' understanding of how changes in fiscal and monetary policy affect the economy
might also benefit from the recognition that households and firms are heterogeneous. For
example, in simple textbook models of the monetary transmission mechanism, central banks
operate largely through the effect of real interest rates on consumption and investment. Once
heterogeneity is taken into account, other important channels emerge. For example, spending by
many households and firms appears to be quite sensitive to changes in labor income, business
sales, or the value of collateral that in turn affects their access to credit-conditions that
monetary policy affects only indirectly. Studying monetary models with heterogeneous agents
more closely could help us shed new light on these aspects of the monetary transmission
mechanism.
While the economics profession has long been aware that these issues matter, their effects had
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been incorporated into macro models only to a very limited extent prior to the financial crisis. I
am glad to now see a greater emphasis on the possible macroeconomic consequences of
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heterogeneity, including in work by economists at the Federal Reserve. Nevertheless, the
various linkages between heterogeneity and aggregate demand are not yet well understood,
either empirically or theoretically. More broadly, even though the tools of monetary policy are
generally not well suited to achieve distributional objectives, it is important for policymakers to
understand and monitor the effects of macroeconomic developments on different groups within
society.
Financial Linkages to the Real Economy
My third question concerns a key issue for monetary policy and macroeconomics that is less
directly addressed by this conference: How does the financial sector interact with the broader
economy?
In light of the housing bubble and subsequent events, policymakers clearly need to better
understand what kinds of developments contribute to financial crises. What is the relationship
between the buildup of excessive leverage and the value of real estate and other types of
collateral, and what factors impede or facilitate the deleveraging process that follows? Does the
economic fallout from a financial crisis depend on the particulars of the crisis, such as whether it
involves widespread damage to household balance sheets? How does the nature and degree of
the interconnections between financial firms affect the propagation and amplification of stress
through the financial system and overall economy? Finally-and most importantly-what can
monetary policy and financial oversight do to reduce the frequency and severity of future crises?
Although the scope of these questions extends beyond the themes of this conference, it does
include issues that are closely related. Consider the influence of balance sheet conditions and
noninterest credit terms on spending and overall activity-an area where it is important to take
account of differences across individual households and firms, as I just noted. Research on this
topic has, of course, been ongoing for some time, and it has expanded greatly in the wake of the
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financial crisis. But I believe we have a lot more to learn about the ways in which changes in
underwriting standards and other determinants of credit availability interact with interest rates to
affect such things as consumer spending, housing demand and home prices, business
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investment (especially for small firms), and the formation of new firms. For example, is the
persistent increase in the personal saving rate that we have observed since the collapse of the
housing bubble primarily a result of a sustained shift toward more prudent underwriting standards
by lenders? Is it something that will ultimately prove transitory once householdsfinish repairing
their balance sheets or become more confident about their future prospects for employment and
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income? The answer to thislatter question could have significant implications for the longer-run
normal, or neutral, level of interest rates and thus for the conduct of monetary policy.
Inflation Dynamics
My fourth question goes to the heart of monetary policy: What determines inflation?
From my perspective, the standard framework for thinking about inflation dynamics used by
central bank economists and others prior to the financial crisis remains conceptually useful
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today. A simple description of this framework might go something like this: Inflation is
characterized by an underlying trend that has been essentially constant since the mid-1990s;
previously, this trend seemed to drift over time, influenced by actual past inflation or other
economic conditions. Theory and evidence suggest that this trend is strongly influenced by
inflation expectations that, in turn, depend on monetary policy. In particular, the remarkable
stability of various measures of expected inflation in recent years presumably represents the
fruits of the Federal Reserve's sustained efforts since the early 1980s to bring down and then
stabilize inflation at a low level. The anchoring of inflation expectations that has resulted from this
policy does not, however, prevent actual inflation from fluctuating from year to year in response to
the temporary influence of movements in energy prices and other disturbances. In addition,
inflation will tend to run above or below its underlying trend to the extent that resource utilization-
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which may serve as an indicator of firms' marginal costs-is persistently high or low.
While this general framework for thinking about the inflation process remains useful, questions
about some of its quantitative features have arisen in the wake of the Great Recession and the
subsequent slow recovery. For example, the influence of labor market conditions on inflation in
recent years seems to be weaker than had been commonly thought prior to the financial crisis.
Although inflation fell during the recession, the decline was quite modest given how high
unemployment rose; likewise, wages and prices rose comparatively little as the labor market
gradually recovered. Whether this reduction in sensitivity was somehow caused by the recession
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or instead pre-dated it and was merely revealed under extreme conditions is unclear. Either
way, the underlying cause is unknown. Does the reduced sensitivity reflect structural changes,
such as globalization or a greater role for intangible capital in production that have reduced the
importance of cyclical swings in domestic activity for firms' marginal costs and pricing power?
Or does it perhaps reflect the well-documented reluctance-or, alternatively, limited ability-of
firms to cut the nominal wages of their employees, which could help to explain the relatively
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moderate movements in inflation we saw during and after the recession?
Another gap in our knowledge about the nature of the inflation process concerns expectations.
Although many theoretical models suggest that actual inflation should be most closely related
to short-run inflation expectations, as an empirical matter, measures of long-run expectations
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appear to explain the data better. Yet another unresolved issue concerns whose expectations
-those of consumers, firms, or investors-are most relevant for wage and price setting, a point
on which theory provides no clear-cut guidance. More generally, the precise manner in which
expectations influence inflation deserves further study.
Perhaps most importantly, we need to know more about the manner in which inflation
expectations are formed and how monetary policy influences them. Ultimately, both actual and
expected inflation are tied to the central bank's inflation target, whether that target is explicit or
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implicit. But how does this anchoring process occur? Does a central bank have to keep actual
inflation near the target rate for many years before inflation expectations completely conform?
Can policymakers instead materially influence inflation expectations directly and quickly by simply
announcing their intention to pursue a particular inflation goal in the future? Or does the truth lie
somewhere in between, with a change in expectations requiring some combination of clear
communications about policymakers' inflation goal, concrete policy actions to demonstrate their
commitment to that goal, and at least some success in moving actual inflation toward its desired
level in order to demonstrate the feasibility of the strategy? Although historical experience
suggests that changing the public's inflation expectations would be neither quick nor easy, it is
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not clear which of these possibilities is correct.
With nominal short-term interest rates at or close to their effective lower bound in many
countries, the broader question of how expectations are formed has taken on heightened
importance. Under such circumstances, many central banks have sought additional ways to
stimulate their economies, including adopting policies that are directly aimed at influencing
expectations of future interest rates and inflation. The unusually explicit and extended guidance
about the likely future path of the federal funds rate that was provided by the FOMC from 2011
through 2014 is an example of such a policy, as is the Bank of Japan's upward revision to its
official inflation objective in 2013. Moreover, these and other expectational strategies may be
needed again in the future, given the likelihood that the global economy may continue to
experience historically low interest rates, thereby making it unlikely that reductions in short-term
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interest rates alone would be an adequate response to a future recession.
For all of these reasons, I hope that researchers will strive to improve our understanding of
inflation dynamics and its interactions with monetary policy.
International Linkages
Before closing, let me mention one additional area where more study is needed-the effects of
changes in U.S. monetary policy on financial and economic conditions in the rest of the world
and the ways in which those foreign effects can feed back to influence conditions here at home.
Of course, cross-country monetary policy spillovers have been the subject of scholarly debate
since the Great Depression, and much of the formal analysis of this topic dates back to the early
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1960s. But this issue has received renewed interest with the advent of unconventional
monetary policies after the Great Recession and, more recently, the divergence of monetary
policies among major advanced-economy central banks.
Broadly speaking, monetary policy actions in one country spill over to other economies through
three main channels: changes in exchange rates; changes in domestic demand, which alter the
economy's imports; and changes in domestic financial conditions-such as interest rates and
asset prices-that, through portfolio balance and other channels, affect financial conditions
abroad. Research by Federal Reserve staff suggests that, all told, U.S. monetary policy
spillovers to other economies are positive-that is, policies designed to provide stimulus to the
U.S. economy also boost activity abroad, as negative effects of dollar depreciation are offset by
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positive effects of higher U.S. imports and easier foreign financial conditions. However, this
issue is far from settled, as are a host of other related questions, including the following: Do U.S.
monetary policy actions affect advanced and emerging market countries differently? Do
conventional and unconventional monetary policies spill over to other countries differently? And to
what extent are U.S. interest rates and financial conditions influenced by easing measures
abroad?
Conclusion
In closing, I would like to commend the Federal Reserve Bank of Boston for organizing this
conference and fostering research and debate on questions vital to our understanding of the
economy. Answering these questions will help the Federal Reserve's efforts to promote a healthy
economy, and I am grateful for the opportunity to speak to you today and be part of this important
discussion.
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