The New Economic ‘Regime’ Challenges Central Bankers

(CTN News) – It has been roughly 30 years since Federal Reserve policymakers and central bankers enjoyed low interest Economic rates, low inflation, a growing supply of labor, and stable markets for goods and services.

By disrupting those trends, the Covid-19 pandemic risks leaving policymakers adrift.

An outbreak of inflation along with stalled labor force growth has already surprised the US central bank. Central bankers will need to keep pace and delve deeper into areas they haven’t traditionally been tasked with, such as industrial organization and supply side economics.

As an economist, Raphael Bostic said last Friday at the American Economic Association (AEA) annual meeting in New Orleans, “identification becomes something of an art form,” when describing economic changes that may be underway.

“Identifying the regime change … understanding the transition dynamics … and having a clear vision and insight into all of them … becomes a very, very challenging task.”

The US labor market has likely changed for the better. This leaves the economy with a shortage of workers and a population making different choices about work, leisure, and retirement than before.

It may be deeper than that.

In New Orleans, the AEA discussed not only the pandemic, but also new geopolitical risks as a result of Russia’s invasion of Ukraine and China’s uncertain position post-pandemic.

In a panel session at the AEA meeting on Saturday, former IMF chief economist Kenneth Rogoff said we may be entering a turning point. A market calibrated to … Chinese growth could fall apart.”

RECENT RESEARCH

The recent correlated downturn challenged portfolio management basics and should spur new research about preparing for future crises, Kristin Forbes, a Massachusetts Institute of Technology professor and former member of the Bank of England’s Monetary Policy Committee, said on the same panel as Rogoff.

Other economic turning points aren’t always obvious at the time, much like recessions.

Data at the time didn’t show a shift to higher productivity, but then-Fed chief Alan Greenspan argued, correctly, that inflation would stay lower than anticipated, requiring lower interest rates.

The profession missed how changes in US mortgage markets allowed broader risks to accumulate and eventually break the financial system, according to former Fed Governor Randall Kroszner.

Professor Kroszner, of the University of Chicago Booth School of Business, said policy must be made in real time. You must have humility and realize that your models, your data, are not necessarily relevant in the future.”

There is a time lag before institutions like the Fed adapt to changes.

In theory, the Fed could keep its policy interest rate low by keeping the neutral rate of interest lower, as well. This would allow economic activity to remain unconstrained and stimulated.

Despite that evidence, it wasn’t embodied in Fed policy until 2020 under a revised approach that avoided premature interest rate increases.

As a consequence, the Fed may now face a world characterized by constrained supply and overheated prices, rather than a chronic shortage of demand and weak inflation.

Inflation has been the subject of new research lines and theoretical frames.

Inflation forecasting could be improved by using “real-time and other novel indicators.” There is no such thing as too much data or analysis when an economy is disrupted.

Monetary policymakers usually consider the supply side of the economy a “given” since their main tool, interest rates, encourage or discourage aggregate demand.

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