One size fit monetary policy for US??

It seems to be a US vs Euro blogposts day. I covered a paper from Fernando Nechio which looked at one size fit monetary policy for Europe. The paper divided the EMU countries into EMU-core and EMU-periphery and showed how ECB’s one size fit policy was  tight for EMU-periphery.

In a new paper Fernando Nechio along with Israel Malkin look at US this time. Just like Europe, US is made of different states/regions and it is a strong chance that some are doing better than the rest. But Fed makes policy for the country as a whole. So, are there problems just like we see in Europe??

In this paper, instead of looking at 50 states, authors divided US into four regions and calculate the Taylor rule for the five regions.

We apply the Taylor rule as shown above to the Census Bureau’s four U.S. regions: Northeast, Midwest, South, and West, comparing the region-specific target rates recommended by the rule with the Federal Reserve’s actual policy rate. We use headline inflation and measured rates of unemployment to construct Taylor-implied rates for each region. In Taylor rule exercises, researchers frequently use core inflation rates, which exclude energy and food prices. However, core inflation data are not available at the regional level. Natural rates of unemployment estimates are also not available by region. Instead, we use the Congressional Budget Office estimated natural rate for the entire United States to construct measures of regional unemployment gaps. The lack of regional natural rate estimates is potentially troublesome, as explained below.

Figure 1 shows the policy rates predicted by the Taylor rule for the four U.S. census regions compared with the Fed’s target rate from 1987 to 2011. For example, at the end of 2011, the Taylor rule predicted policy rates ranging from 0.35% in the West to 3% in the Midwest, while the target federal funds rate was at 0–0.25%. The figure also shows that the dispersion of the regional Taylor rule implied rates has not been very large throughout the sample. Due to the financial crisis of 2008, the implied rates decreased substantially for all U.S. regions and dispersion across regions has increased since then. The bulk of the regional dispersion of the predicted rates stems from the differences in the sizes of the unemployment gaps across the four U.S. regions.

Chart 2 shows than in 3 regions out of 4, Taylor rule indicates Fed funds rate should be higher than current 0-0.25% Only in  West region which includes California Taylor rule shows current rates are appropriate. So is the Fed making the policy only for West region? As Fed plans to keep rates at zero till 2014, what will happen in the other 3 regions? A sense of dejavu with bubbles building up as people look for higher returns?

Despite one size not fitting all even in US, the differences are much lower than seen in Europe? Why? The authors says it is because of higher labor mobility in US and presence of fiscal union:

Dispersion among Taylor-implied regional policy rates in the United States is much smaller than the large discrepancies between core and peripheral countries in the euro area, as shown in Nechio (2011).  ispersion among Taylor-implied regional policy rates in the United States is much smaller than the large discrepancies between core and peripheral countries in the euro area, as shown in Nechio (2011). Figure 2 reproduces a figure from Nechio (2011), but instead uses headline inflation to make it comparable to the U.S. regional data in this Letter. In the euro area in 2011, the Taylor rule predicted policy rates range from a negative 2% in the periphery to a positive 5% in the core. That’s more than twice as wide as the gap between Taylor rule predictions for U.S. regions.

One reason for the smaller divergence in the United States is its relatively larger factor mobility, in particular, its freer movement of labor. In addition, the United States operates under a single federal budgetary regime. By contrast, each European country has considerable leeway in determining its own fiscal policy.  If labor and capital can move freely across the nation, economic disparities cannot easily persist. If one region is hit by a negative economic shock and another region faces better growth prospects, unemployed workers in the slumping region can migrate to the economically stronger area. Such migration narrows the differences between the unemployment rates in the two regions.

The United States also uses fiscal policy to promote balance among regions. Obstfeld and Peri (1998) show that the United States relies heavily on fiscal transfers to offset region-specific shocks. By contrast, in the euro area, fiscal policy is an option that is not fully available because tax and spending decisions are largely sovereign. Nonetheless, the option of using fiscal tools would be especially helpful in addressing the problems of heavily indebted peripheral countries.

It points to research which shows labor mobility is higher in US..

This EMU episode makes one look at all the countries. What about India? Here states are so different but RBI makes monetary policy for pan-India. It will be a nice exercise to see whether RBI’s policy fits all or not…Most likely not…Then which states are effected the most??

And then so far, we do not really see state ministers criticising RBI for their woes. They mostly goto the centre for relief/aid/help. May be the know-how about RBI and how it impacts therm is not as great. May be with passing of time, state ministers start to criticize and question RBI moves as well.



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