“Because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.”
Let’s break the above quote apart and put it in perspective:
- Waiting with rate hikes until inflation materializes is undesirable.
- This is particularly true today after years of global QE and zero-interest-rate policy, when “outsized deviations of inflation” – such as a sudden and hard-to-control surge – “are a plausible outcome.”
The quote is the conclusion of the 39-page research paper by five economists at the Board of Governors of the Federal Reserve, of which Jerome Powell is chairman. The researchers used stochastic simulations to outline how two uncertainties – inflation dynamics and something the Fed calls the natural rate of unemployment (we’ll get to them in a moment) – “affect the choice of strategies for monetary policy.”
The paper was released with careful timing ahead of Powell’s speech at the Jackson Hole symposium, where he defended the Fed’s “gradual” approach to rate hikes against attacks from both sides – those saying they weren’t fast enough, given what’s happening on the inflation front, and those saying that the only good money is cheap money.
The paper wasn’t so balanced. It gave fuel to the discussion at the Fed on how fast to raise rates now that inflation has hit the Fed’s target of 2%, based on the Fed’s preferred measure, core PCE, which has been hovering between 1.9% and 2.0% since May.
The crux is the relationship between the unemployment rate (3.9% in July), a level traditionally associated with effects where labor market tightness leads to rising wages which then pushes up prices. This is the classic model, embodied by the Phillips curve.
Diminishing “labor market slack” is held responsible for wage increases, and therefore higher demand, which leads to higher inflation.
In terms of this slack, the research by the Fed economists focuses on the “natural rate of unemployment” (u*). For monetary policy setters, this is a key variable. If unemployment falls below this rate, whatever this rate may be, the economy begins to build up inflation pressures.
The Congressional Budget Office releases its own estimates of a similar concept, the Non-Accelerating Inflation Rate of Unemployment, or NAIRU, which currently is pegged at 4.55%.
Neither NAIRU nor the “natural rate of unemployment” (u*) can be measured but must be inferred from other information. As central as this rate is to the entire rate-hike debate, it’s too squishy to be nailed down, and it’s mobile – it has dropped substantially since the Great Recession.
“We’re learning about the real location of the natural rate of unemployment as we go,” explained Powell in response to a question at the press conference after the June 13 meeting. “It has moved down by more than a full percentage point since 2012. So it’s not so simple as thinking we’ve just got to go ahead and get the rate up.”
Where is this rate today? There’s “a range of views,” Powell said. “Some people [on the FOMC] are in the low 4’s.” But…
“We can’t be too attached to these unobservable variables. I think we have to be practical about the way we think about these things and we do that by being grounded in the data and what we see happening in the real economy.”
OK, I got that. The Fed doesn’t have a good handle on where this natural rate of unemployment is, but it must make interest rate decisions based on it.
The principle is this: Once unemployment (currently 3.9%) falls below u* (Fed estimates for u* range from the “low 4s” to around 4.7%), inflation starts to take off, and the Fed has to raise rates to nudge up the unemployment rate to say 4.5% or 5% in order to nudge down inflation.
But there are lags at every stage along the way:
- Between rate hikes and when unemployment begins rising
- Between rising unemployment and when demand begins to back off
- And between when demand backs off and the moment inflation begins to edge back down.
This lag is key. During that lag, inflation may overshoot because the process takes too long, and then the Fed has to tighten more and faster to grapple with higher inflation, which causes the unemployment rate to jump far higher than originally planned. And voilà, a mess called a recession – or worse.
And so we get the concise answer of their research, stochastic simulations, charts, and tables in the paper’s conclusion:
This paper has shown that because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.
This is a straightforward counterpoint to a few FOMC members (such as St. Louis Fed President James Bullard) who continue to argue that moving more slowly, or not moving at all, on interest rates is preferable at this time because inflation is still not above target – a school of thought that sees it as preferable to let inflation run hot before raising rates, regardless of what comes afterwards.
The paper lays the intellectual foundation – the type economists appreciate – for pushing on with rate hikes until somewhat higher unemployment prevents inflation from taking off, under ideal circumstances.
But more likely, since inflation may already have taken off by then, given the lag, even higher rates would be needed to nudge up unemployment even further to bring inflation back down before it gets out of hand entirely, a risk that the paper outlines, as “outsized deviations of inflation from its target are a plausible outcome,” and which should be avoided by not waiting for above-target inflation to materialize.
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