Why monetary policy is so tricky for the Fed

How far is the economy from a full recovery? When should Federal Reserve policymakers, who are finishing their two-day meeting today, begin raising interest rates? Should the Fed speed the pace of its tapering of quantitative easing?

All of these questions depend critically on a piece of data economists call the output gap, the difference between actual output and the economy's potential, or the full employment level. Unfortunately, however, both of these quantities are difficult to measure, leaving policymakers at least partially in the dark as to the state of the economy.

The difficulty with measuring GDP is the substantial lag before this essential data is available. It's known to policymakers only after a one-quarter delay, and even then it's subject to substantial revision over time.

Policymakers can look at other data such as the unemployment rate, the employment-to-population ratio, capacity utilization, retail sales, consumer and business confidence, and so on, but these don't provide a precise picture, meaning uncertainty surrounds the actual state of the economy at any moment in time.

Measuring the economy' potential is even harder. Data on potential GDP cannot be collected in the same way we collect data on actual GDP. Instead it must be estimated from economic models, or calculated through assumptions about what full employment is (e.g. 5 percent unemployment, but why not 5.1 percent or 4.9 percent?).

A recent paper by Federal Reserve of San Francisco economist John Fernald took on this task, and it found that the growth in potential output has slowed recently. Fernald traced this to changes that occurred prior to the Great Recession. Thus, the slowdown isn't the result of that slump. Instead, Fernald found the "slowdown is located in industries that produce information technology (IT) or that use IT intensively, consistent with a return to normal productivity growth after nearly a decade of exceptional IT-fueled gains."

This is important to policymakers because, as Fernald noted, "Slower underlying productivity growth implies less economic slack than recently estimated by the Congressional Budget Office." If this is true, it means the economy has less need for stimulus than previously thought, and hence the Fed ought to begin reversing its interest rate and quantitative easing measures sooner than many analysts have predicted.

However, it's important to remember that this is only one study, and it could be wrong. Given this possibility and given that the costs of overshooting the Fed's inflation target are much smaller than the costs of unemployment, many economists believe the Fed should wait until there are clear signs that we're running up against capacity constraints before taking action to reverse course.

So far those signs -- wage and price inflation, for example -- aren't yet in evidence. We'll see what the Fed does today and what it signals about future moves. Good arguments can be made on both sides, but there's certainly a case to be made for "watchful waiting" rather than decisive action.