NEW YORK (MNI) – The following is the third of seven sections of
Federal Reserve Vice Chair Janet Yellen’s text and footnotes prepared
Wednesday for the Money Marketeers of New York University:

One consideration that further complicates this outlook is the
inconsistency between recent movements in economic growth and
employment: Unemployment has declined significantly over the past year
even though growth appears to have been only moderate. This
unanticipated decline in the unemployment rate presents something of a
puzzle, and it creates uncertainties for the outlook and policy.

To illustrate this puzzle, figure 5 plots changes in the
unemployment rate against real GDP growth–a simple portrayal of the
relationship known as Okuns law. It is evident from the figure that
2011 is something of an outlier, with the drop in the unemployment rate
last year much larger than would seem consistent with real GDP growth
below 2 percent. One possibility, highlighted by Chairman Bernanke in a
recent speech, is that last years decline in unemployment represents a
catch-up from the especially large job losses during late 2008 and
2009.7 According to this hypothesis, employers slashed employment
especially sharply during the recession, perhaps out of concern that the
contraction could become even more severe; in particular, the figure
shows that in 2009, the unemployment rate rose by considerably more than
the decline in GDP would have suggested. Then, last year, employers may
have become confident enough in the recovery to increase hiring and
relieve the unsustainable strain that the earlier cutbacks had placed on
their workforces. I think the evidence is consistent with this
hypothesis, and I have incorporated it into my own modal forecast.

If last years Okuns law puzzle was largely the result of such a
catch-up in hiring, I would expect progress on the unemployment front to
diminish unless the pace of GDP growth picks up. After all, catch-up can
go on for only so long. Of course, there are other conceivable
explanations for this puzzle, including some that would point to a
faster decline in unemployment in coming years. For example, GDP could
have risen more rapidly over the past year than current data indicate.
It will be important to pay close attention to indicators of both the
labor market and GDP to try to gauge the likely pace of improvement in
economic activity going forward and, hence, the appropriate stance of
monetary policy over time.

Let me now turn to inflation. Overall consumer price inflation has
fluctuated quite a bit in recent years, largely reflecting movements in
prices for oil and other commodities. For example, inflation moved up in
the first part of 2011 as a rise in the price of oil and other
commodities fed through to gasoline prices, and, to a lesser extent, to
prices of other goods and services. Then inflation subsided after
commodity prices came off their peaks. More recently, prices of crude
oil, and thus of gasoline, have turned up again. But smoothing through
these fluctuations, inflation as measured by the personal consumption
expenditures (PCE) price index averaged 2 percent over the past two
years. Using the price index excluding food and energy–another rough
way to abstract from transitory fluctuations–inflation averaged about
1-1/2 percent over the past two years. These rates are lower than the
inflation rates that were seen prior to the recession, and they are at
or below the FOMCs long-run goal of 2 percent inflation.

In my view, the subdued inflation environment largely reflects two
factors. First, the substantial slack in the labor market has restrained
inflation by holding down labor costs. Second, and of critical
importance, longer-term inflation expectations have been remarkably
stable. Like many other observers, I was concerned that inflation
expectations might move lower during the recession, driving down both
wages and prices in a self-reinforcing spiral.

The Federal Reserve acted forcefully to resist such an outcome and,
fortunately, that destructive dynamic did not take hold. Indeed, the
stability of expectations has meant that the price increases driven by
costs of oil and other commodities have had only temporary effects on
the rate of inflation. Although firms passed higher input costs into
their prices when they could do so, those one-time price increases have
not led to an expectations-driven process that might have resulted in
persistently higher inflation. The same key factors that have kept core
inflation subdued provide the rationale for my inflation forecast.

I anticipate that slack in the labor market will continue to
restrain growth in labor costs and prices. And, given the stability of
inflation expectations, I expect that the latest round of gasoline price
increases will also have only a temporary effect on overall inflation.
Indeed, if crude oil prices were to follow the downward-sloping path
implied by current futures contracts, energy costs would serve as a
restraining influence on overall inflation over the next several years.
Figure 6 presents the central tendency of FOMC participants projections
of inflation at the time of our January meeting. Most expected inflation
to be at, or a bit below, our long-run objective of 2 percent through
2014; most private forecasters also appear to expect inflation by this
measure to be close to 2 percent.8 As with unemployment, uncertainty
around the inflation projection is substantial. Benchmarks for Assessing
Monetary Policy: Optimal Control As I indicated at the outset of my
remarks, I supported the Committees statements in January and March
pertaining to the stance of monetary policy.

I will now explain the rationale for my judgments, and I will
describe some of the tools that I use to make such assessments. I
consider it essential, in making judgments about the stance of policy,
to recognize at the outset the limits of our understanding regarding the
dynamics of the economy and the transmission of monetary policy. Because
I see no magic bullet for determining the right stance of policy, I
commonly consider a number of different approaches. One approach I find
helpful in judging an appropriate path for policy is based on optimal
control techniques. Optimal control can be used, under certain
assumptions, to obtain a prescription for the path of monetary policy
conditional on a baseline forecast of economic conditions. Optimal
control typically involves the selection of a particular model to
represent the dynamics of the economy as well as the specification of a
loss function that represents the social costs of deviations of
inflation from the Committees longer-run goal and of deviations of
unemployment from its longer-run normal rate. In effect, this approach
assumes that the policymaker has perfect foresight about the evolution
of the economy and that the private sector can fully anticipate the
future path of monetary policy; that is, the central banks plans are
completely transparent and credible to the public.9

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