Simple plots of recent GDP and inflation data highlight two profoundly important questions facing monetary policymakers in the United States. GDP is at a level several percentage points below reasonable estimates of its pre-crisis trajectory (Fig. 1):^[1] Will we ever regain that lost output? Inflation had run well below the Fed’s objective for the two years prior to the recent plunge (Fig. 2):^[2] Will inflation bounce back, all the way back, to the Fed’s target?

While these questions are hotly debated in Congress and the private sector, not to mention in the Fed, a realist should admit that no amount of study or debate will greatly clarify the answers in the near term. Policy will have to be made in light of considerable uncertainty about these matters. Perhaps paradoxically, we believe that the uncertainty we face renders some broad judgments about the appropriate stance of policy more clear. Specifically, we think dual mandate considerations favor continuation of highly accommodative policy.

Consider inflation. We can be fairly confident that the recent downward move in inflation is largely due to the drop in oil prices and rise in the value of the dollar. While these forces are very likely transitory, it’s not certain that inflation will bounce back promptly once they pass. Moreover, we have little reason to suppose that, when inflation bounces back to mid-2014 levels, it will then rise above the sub-2 levels it had been stuck at since 2012.

Setting aside other considerations for the moment, we think this uncertainty argues strongly for continued highly accommodative policy. The logic? If the accommodation proves excessive and inflation begins to rise, the Fed has a considerable cushion before inflation rises above 2, and it also has well-tested tools for stemming an incipient spell of undesirably high inflation. In contrast, with interest rates near zero, no central bank has proven tools for responding if inflation gets stuck at some low level. Further, the costs of a high-side and low-side miss on inflation may be quite different at present. We’ve regularly experienced brief spells with inflation somewhat above 2, with modest costs. On the other hand, with inflation near zero, even a small negative shock could move us toward deflation. Nobody knows much about why deflationary spells seem to be so costly to end, but that very lack of knowledge is probably a good reason to lean toward avoiding one.

One cost of a highly accommodative policy could be pushing the economy above its maximum sustainable level of employment. This brings us to the other side of the Fed’s dual mandate. Most analysts do not currently gauge pressure in the labor market to be near the bursting point. Still, it is probably true that if the headline unemployment rate were the sole arbiter of economic slack, we would conclude that the economy was approaching full resource utilization. We would, therefore, probably conclude that the stance of monetary policy should be on the way back, perhaps well on the way back, to normal.

Other measures of the labor market, however, suggest that there is considerable remaining slack—slack that might account for a good portion of the missing GDP in Fig. 1. For example, suppose highly accommodative policy helped bring prime age labor force participation and part-time work back near pre-recession levels. This might close a third or more of the gap in Fig. 1. Many similar scenarios are difficult to dismiss with any certainty, but we also cannot dismiss the possibility that the lagging employment and output are here to stay.

Once again, in the face of this uncertainty, a highly accommodative policy is the prudent step. The logic? If we are near capacity, then highly accommodative policy may lead to a brief period of employment above its maximum sustainable level, perhaps precipitating rise in inflation pressures. However, upward pressure on inflation would be welcome at present, and the Fed, has proven tools to use if the pressure proves greater than desired. Except for inflation pressure, it is not clear there are large costs of employment rising briefly above its maximum sustainable level. In contrast, if there is significant remaining slack, removal of accommodation would bring a real risk that persistent slack will become even more intractable.

We think that these arguments—based on uncertainty, risks, and on the policy tools available for managing those risks—constitute a very strong case for highly accommodative policy.

So what do we predict for policy? We would be shocked if the FOMC moved away from a highly accommodative stance until there is greater clarity on at least one of the two questions we started with. As for the liftoff of interest rates—that’s a different matter entirely.

In anyone’s estimation, even after liftoff the extraordinarily low short-term rates and the Fed’s large holdings of longer-term securities will imply a highly accommodative policy stance. The contentions laid out above mainly reinforce the message in much recent FOMC communication. An initial move to raise the fed funds rate will not signal the commencement of a rapid return to normal.

So liftoff in June or September? Fortunately, so long as most everyone remembers that post-lift-off policy will remain highly accommodative, the particular timing of liftoff should not matter much—except to those who elect to gamble on it.

Footnotes

1.Those red lines on fig. 1 are simply meant to highlight that there might be ground to make up. Cecchetti and Schoenholtz make uncertainty on this point the subject of an excellent recent post. [back]

2.The Fed’s 2 percent objective is for inflation measured by the personal consumption expenditures price index. This index tends to run a bit below the CPI measure of inflation, suggesting that we have a bit more ground to make up than represented in Fig 2.[back]