Forecasting that the Unemployment Rate will stay Constant is a Bad Idea

Jim Bullard, President of the St Louis Fed, has released a new, St Louis Fed model, for thinking about the way the Fed forecasts. According to the St Louis model, we should think about 'regimes'. There are three components to regimes. 1) Is the economy in a recession: YES or NO? 2) Is the short-term real interest rate HIGH or LOW? 3) Is productivity growth HIGH or LOW? 

Putting these pieces together, there are eight possible states. Recession can be YES or NO,  productivity can be HIGH or LOW and the natural real interest rate (Jim calls this R Dagger) can be HIGH or LOW. 

In Bullard's view the current regime is

Recession: NO,      Productivity growth: LOW,    R Dagger:   LOW

Using regime dependent forecasting, Jim thinks the best forecast of the US economy, moving forwards, is that productivity growth will stay low and the unemployment rate will stay where it is. That implies, according to Bullard, that the Fed should hold the interest rate at 63 basis points through 2018. 

I have one big problem with this forecasting framework. Take a look at the figure above which depicts US unemployment since 1950. Jim Bullard wants to talk about a 'regime dependent equilibrium'. I have no problem with that idea. But there is no period in the post-war period when the unemployment rate was even approximately constant. It was either increasing or it was decreasing.  If we stick with the regime dependent paradigm, I would replace, [Recession = Yes or NO], with, [Unemployment = INCREASING or DECREASING].

That may seem like a semantic change. But it makes a big difference to a regime dependent forecasting model because the unemployment rate cannot keep falling forever. That suggests that, the longer we are in the [Unemployment = DECREASING] state, the higher is the probability of a regime switch into [Unemployment = INCREASING]. That suggests to me, that the risk of another recession while productivity and the natural real interest rate are low is higher than Jim Bullard thinks. 

I'm glad that the St Louis Fed has moved to this new framework as I've argued for a long time that the existing paradigm is broken.

You can preorder my book, Prosperity for All, which says a lot more about these issues, HERE.