Economists may not see eye to eye on much, but over the years I’ve found a few core concepts on which all but the most politically motivated would agree.
One is that inflation is a monetary phenomenon -- “always and everywhere,” to quote the late Nobel laureate Milton Friedman. Another is that there is no long-term trade-off between inflation and unemployment, a relationship expressed by the Phillips Curve.
Friedman, again, along with fellow Nobel laureate Edmund Phelps, argued that any attempt to push unemployment below a so- called “natural rate” would backfire when workers realized the higher wages offered them were a “money illusion” and prices were rising even faster. Their augmented Phillips Curve became the accepted way to explain the coexistence of high inflation and high unemployment in the 1970s.
So why would the Federal Reserve be willing to risk higher inflation for, at best, a short-run boost to employment? The simple answer is that some policy makers don’t see it as a risk. Today’s 9.1 percent unemployment rate is well above what’s considered full employment in the U.S., giving the Fed leeway to advance one of its dual mandates (maximum employment) without compromising the other (stable prices).
Fed governors Daniel Tarullo and Janet Yellen are already on record as ready or willing to expand the Fed’s $2.86 trillion balance sheet. And if they can help the housing market in the process -- print money to buy mortgage-backed securities -- so much the better!
Casting Long Shadow
Not everyone is so sanguine about further stimulus. Three Fed District Bank presidents dissented at the last two meetings, opposing August’s pledge to keep the funds rate near zero through mid-2013 and the decision in September to extend the maturity of the Fed’s securities portfolio.
Members of the Shadow Open Market Committee, a group of independent economists who meet twice a year to evaluate the Fed’s policy choices, are similarly inclined. The papers presented at the Oct. 21 meeting argue against further Fed actions.
“Aggressive monetary policy at the zero bound should be used only if deflation becomes a clear and present danger,” Marvin Goodfriend, professor of economics at Carnegie Mellon University in Pittsburgh and a shadow committee member, writes in his paper.
Deflation isn’t a danger. The consumer price index rose 3.9 percent in the year that ended in September, while the CPI excluding food and energy was up 2 percent. As recently as October 2010, the year-over-year increase in the core CPI was 0.6 percent.
Nor are inflation expectations, the Fed’s sine qua non, flashing red, or even yellow. The central bank’s own measure of inflation expectations five to 10 years out stands at 2.5 percent, above the 2 percent implicit target.
In his paper, Goodfriend divides what he calls “inflationist proposals” into three groups: those willing to risk higher inflation, those willing to tolerate higher inflation, and those willing to target higher inflation.
Tarullo and Yellen, as mentioned above, are in the “risk” camp. They look at measures of excess slack in the economy -- things like the rates of unemployment and capacity utilization - - and conclude there’s room for further stimulus. Curiously, the quasi-monetarists, who advocate maintaining a constant level of nominal gross domestic product, think the Fed should embark on additional asset purchases as well.
Some respected economists, including Harvard’s Ken Rogoff and the International Monetary Fund’s Oliver Blanchard, are in the “target” camp. In their view, higher inflation would help the deleveraging process by allowing debtors to pay back their loans in devalued dollars. (Savers get hosed.)
‘Flying Blind’
Who’s in the “tolerate” camp?
“The silent majority of economists,” Goodfriend says. They don’t see inflation as a real risk, and if they’re wrong, the attitude is that the Fed can always deal with it later.
Later has consequences. The lesson of the 1970s is that any short-run employment benefits from tolerating higher inflation today, which are “questionable,” create adverse long-term effects, requiring tighter monetary policy, he says.
Policy makers rely on econometric models to forecast things like GDP growth, inflation and the output gap, a squishy concept that’s supposed to reflect the difference between actual and potential GDP. It’s the perceived output gap -- and particularly excess supply of labor -- that has some Fed officials willing to restart the printing press.
Goodfriend says inflation is indicative of the size of the output gap. And inflation isn’t falling. Some economists posit that extended unemployment benefits and a mismatch between the skills offered by the unemployed and those required by employers have raised the natural rate.
Or it may be that, given the anemic recovery, the labor market just isn’t “clearing,” Goodfriend says. Something is preventing buyers (employers) and sellers (employees) from finding the equilibrium price (wage) where supply equals demand.
That’s why targeting an unemployment rate or an output gap is a poor idea, the equivalent of “flying blind,” he says. Not to mention the consistent failure of the Fed’s models to predict outcomes.
It used to be an article of faith among central bankers that price stability is both an end in itself and the means to an end: maximum employment. Fed chief Ben Bernanke has said as much, though not recently.
With the Fed under tremendous pressure -- implicit, not explicit -- to do something, anything, to help a floundering economy, Bernanke saw fit to remind Congress of the limits of the central bank’s powers.
“Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy,” Bernanke said Oct. 4 in prepared testimony to the Joint Economic Committee of Congress.
That would make a good wall poster for the boardroom where Fed officials meet next week to discuss policy options.
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