DAVID BLANCHFLOWER: The Fed's misleading view of the job market reflects 'a huge intellectual failure'

Janet Yellen Stanley FischerFlickr / Federal ReserveJanet Yellen and Stanley Fischer.

The Federal Reserve is making a big policy error by raising interest rates, and it is doing so because policymakers are wedded to failed economic models that ignore deep underemployment and a weak underlying economic environment.

That’s the view of David Blanchflower, a former member of the Bank of England’s Monetary Policy Committee who is now a professor at Dartmouth College.

Blanchflower told Business Insider in an interview that the Fed was vastly overestimating the labour market’s true strength by focusing too heavily on the historically low headline unemployment rate, which registered 4.4% in June.

“Prior to 2008, the unemployment rate was a sufficient statistic to tell you about the labour market,” Blanchflower said. “The employment rate was mirror image.”

Today, however, “a cyclical decline in demand means the unemployment rate has fallen but the employment rate has not recovered to precrisis levels,” he said. In other words, the economy is still too weak to sustain full employment, and policymakers are not doing enough about it.

Explaining the gap are high levels of long-term unemployment and severe underemployment, in addition to persistent racial disparities in job availability and incomes.

“Why are you raising rates?” he said. “Inflation is weak because we’re in a cyclical down point — there’s much more slack than the unemployment rate suggests,” he said.

There’s probably a mix of reasons. Among those is pressure from interest groups like banks, which begged for rate cuts during the crisis but are now tired of the subpar returns associated with a prolonged low-rate environment. But another important factor is that policymakers are wedded to the concept of the Phillips curve, a model that simplistically says inflation is sure to spike once the labour market tightens enough.

This view is reflected in the curious concern expressed by policymakers like William Dudley of the New York Fed and John Williams of the San Francisco Fed who think the unemployment rate may somehow be falling too quickly — as if this were a bad thing.

“This is a huge intellectual failure,” said Blanchflower, who is working on a book on the labour market. “Economics was nothing more than drawing a straight line and thinking it would continue.”

“If these guys were right, then why would people have voted for jobs, jobs, jobs, and Donald Trump?” he added.

The same inflation hawks within and outside the central bank have been warning about imminent inflation for years, Blanchflower said, only to be proved wrong time and again: “It’s really here, it’s really coming, it’s really coming, inflation is right around the corner.”

Indeed, it never has. US inflation continues to undershoot the Fed’s 2% target, and it is in fact moving further below it, despite a low headline jobless rate. This suggests there’s much room for improvement yet, something most jobseekers would attest to.

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