The Fed and Unemployment

The abstract for a working paper by James K Galbraith, Olivier Giovannoni, and Ann J Russo, "The Fed’s Real Reaction Function: Monetary Policy, Inflation, Unemployment, Inequality and Presidential Politics"

Using a VAR model of the American economy from 1984 to 2003 we find that, contrary to official claims, the Federal Reserve does not target inflation or react to “inflation signals.” Rather, the Fed reacts to the very “real” signal sent by unemployment; in a way that suggests that a baseless fear of full employment is a principal force behind monetary policy. Tests of variations in the workings of a Taylor Rule, using dummy variable regressions, on data going back to 1969 suggest that after 1983 the Federal Reserve largely ceased reacting to inflation or high unemployment, but continued to react when unemployment fell “too low.” We further find that monetary policy (measured by the yield curve) has significant causal impact on pay inequality–a domain where the Federal Reserve refuses responsibility. Finally, we test whether Federal Reserve policy has exhibited a pattern of partisan bias in presidential election years, with results that suggest the presence of such bias, after controlling for the effects of inflation and unemployment.

The first thing I've highlighted, about the change in Fed policy away from actually dealing with unemployment, is something that I've been thinking about a lot lately, and so it was nice to see some evidence for this. I had never really considered the effect of monetary policy on pay inequality, so this was also very interesting. As for partisan bias, I'm not terribly surprised. But I think it's the least substantively worrying element here. Really, the idea that there has been an effective abdication of dealing with high unemployment by the one institution that can make an enormous difference (either through monetary policy or by making sure that if fiscal policy is used that it is not undermined by monetary policy). Well worth a read.