For much of the past two years, the president of the Federal Reserve Bank of Minneapolis has argued that monetary policy could do little to cure high unemployment because shifts in the economy had created a mismatch between workers' skills and available jobs.
But Narayana Kocherlakota's view has changed.
He has become one of the leading voices calling for the Fed to keep interest rates low indefinitely. As long as it isn't causing inflation, he reiterated Wednesday, the central bank "should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent."
His change of heart reflects a subtle but important shift in how economists answer a very big question: Do we have a struggling economy, or do we have one that's fundamentally changed?
If 8 percent unemployment is the new standard in a new economy, then low interest rates won't lead to jobs for anybody. "If you really believe it's all about structural, frictional unemployment, it really doesn't matter what the Fed does," said Peter Ferderer, who teaches economics at Macalester College in St. Paul.
Unemployment should fall as job openings rise. If both numbers increase, the economy is creating jobs for which there are no workers, while leaving other workers jobless because no openings fit their skills or geography.
In August 2010, American unemployment was 9.6 percent despite a 20 percent rise in job openings over the previous 12 months, and economists began to believe the problem was a labor mismatch.
One of those was Kocherlakota.
"Firms have jobs, but can't find appropriate workers. The workers want to work, but can't find appropriate jobs," he said in a speech at Marquette, Mich., in August 2010.
"There are many possible sources of mismatch -- geography, skills, demography -- and they are probably all at work," he said then. "Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. ... The Fed does not have a means to transform construction workers into manufacturing workers."
In fact, Kocherlakota argued earlier this year, easy monetary policy aimed at reducing structural employment could lead to inflation.
But if the problem is simply a bad economy, or cyclical weakness in demand, then low interest rates can help stimulate growth and the Fed should hold them down.
Rethinking a theory
Economists have been chipping away at the labor mismatch theory for the past year, and a few studies have shown that the employment problem is cyclical, not structural, undercutting the argument against low interest rates.
A key paper presented at a symposium in Jackson Hole, Wyo., by Stanford University economist Edward Lazear in September said "there are no structural changes that can explain movements in unemployment rates over recent years."
Lazear's paper included analysis showing that while unemployment is higher across industries and job openings are fewer, no industry displays a dramatic deviation from the classic relationship between the two. Not even construction, which took a huge wallop in the recession and has struggled to recover as the housing market shuffles along.
While not currently a voting member of the rate-setting Federal Open Market Committee, Kocherlakota, like all regional presidents, participates in the meetings. He first announced his support for keeping low interest rates until unemployment falls to 5.5 percent less than a week after the Fed announced that it would conduct a third round of quantitative easing, an effort to further drive down interest rates by purchasing long-term securities.
On Wednesday in Great Falls, Mont., he reiterated his call for the Fed to promise it will hold interest rates down until either unemployment falls below 5.5 percent or the medium-term inflation outlook rises above 2.25 percent. The proposal provides an "automatic stabilizer," Kocherlakota said, allowing the Fed to easily respond to a growing or shrinking economy.
If the public believes that the Fed will start raising interest rates when unemployment falls below 7 percent, or even below 6 percent, he said, people will be more reluctant to spend money and the economy will recover more slowly.
Despite fluctuations in gasoline prices, inflation is not imminent, he said, and likely won't be until unemployment falls below 6 percent.
"The basic economics underlying the plan is that if people's expectations about their future prospects improve, they will save less," he said Wednesday. "The reduced need for savings would translate directly into spending more today."
Adam Belz • 612-673-4405 • Twitter: @adambelz