If Federal Reserve Chairman Ben Bernanke steps down next year, his successor may be Janet Yellen. In a recent statement, she indicated that unemployment should become the priority for the Fed. It seems reasonable to want to aim all our policy guns at this plague. But many things that seem reasonable on the surface sometimes appear dead wrong after looking into them more closely.
In a recent speech, Janet Yellen was quoted in several newspapers saying the following: "With unemployment so far from its longer-run normal level, I believe progress on reducing unemployment should take center stage for the [Federal Open Market Committee], even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent."
This seemingly innocuous statement deserves more attention, especially since until 1978 the Fed had a singular mandate — to use its tools to pursue price stability. The European Central bank (ECB) also has a similar singular mandate. But the Humphrey-Hawkins Act of 1978 created a dual mandate for the Fed — including price stability and full employment as its two key goals.
While Yellen’s quote sounds reasonable, there are some who acknowledge that until 2008, the Fed acted as if it still operated largely with a single price stability mandate. Attaining full employment was a secondary objective, at least until recently. Fiscal Policy was thought to be the more appropriate means to deal with employment and economic growth.
There are some who believe that Yellen and some others on the board would like to permanently create more balance between the two goals — raising the stature of employment and growth in the Fed’s work. Yellen will hoist full employment above price stability for the foreseeable future.
Yellen and others are making all of us take a very clear risk. Is it worth it?
It is understandable that national interest should be concerned about employment and economic growth. It seems reasonable to want to aim all our policy guns at this plague. Changing the Fed’s objective to favor employment, however, would be very risky, inefficient, and wasteful. Why?
First, the United States had a single price stability mandate for about 60 years. The ECB insisted on this single mandate, and despite what appears to be some wavering recently, the ECB continues with it. There must be strong reasoning behind the Fed focusing on price stability.
Second, John M. Keynes invented something called the liquidity trap. Modern Keynesians dispensed with this extreme behavioral assumption, but maintained models that always had a preference for fiscal policy over monetary policy as it had to do with affecting real variables like employment and output. In turn, Keynesians didn’t think much about using monetary policy to control employment and output.
Third, Monetarists challenged Keynesians by admitting that, in the short-run, monetary policy could have a very large impact on employment and output. But Monetarists insisted that these impacts were possible only if the stimulus policy was unexpected. Thus, it had to be a surprise to be effective.
In the longer-term, the effects would dissipate as the impact was fully understood. So-called Neo-Keynesians agreed that such monetary surprises had only a short-term impact. Both groups of economists also agreed that part of the undoing of the short-term impacts was eventual increasing inflation and interest rates.
Fourth, much of the discussion today assumes that there is no need to worry about the Fed’s recent and future monetary explosion having an upward impact on inflation and interest rates. But history is clearly rife with examples of inflation catching up when least expected. Policymakers have been caught many times with their guard down. And like magic, inflation that was no where in sight seemed to miraculously appear.
Inflation can be like a fire: it quickly spreads and often requires the big hoses — an action that can ruin the kitchen. When inflation hits, the Fed acts quickly to eradicate it. Episodes of extreme fed tightening have led to either pronounced decreases in economic growth or absolute reductions in output. In fact, several dismal time periods followed tight money policies in 1956, 1960, 1968, 1973, 1978, 1980, 1989, and 2000.
The Fed indicates it will do better this time and will know when to pull out the money in a reasonable way that does not disturb the economy. History is not on the Fed’s side.
Fifth, Yellen and others are making all of us take a very clear risk. Is it worth it?
Many admit it’s possible that focusing on employment today will bring more inflation sometime in the future. But many in this camp believe this risk is minimal compared to the pains of today’s unemployed. However, they do not fully appreciate the real problems caused by inflation.
As noted above, when inflation comes it might first rise slowly to levels slightly above the 2-3 percent range. But experience in other countries, as well as the U.S., indicates that once inflation starts rising it is very difficult to contain. That is why countries try so hard to maintain price stability.
In the recent past, Turkey, Brazil, and Israel experienced inflation rates above 100 percent per year. If you speak with people in those countries who lived through these events, you’ll know why people prefer price stability.
Many believe this can’t happen in the United States and now. But hyperinflation has to start somewhere — even at 3 percent. Importantly, inflation often turns into hyperinflation because governments can’t constrain their spending and the central banks monetized and compounded these political errors.
What is the impact of inflation? Workers often receive higher wages, but since inflation rises faster than their incomes, their purchasing power decreases. Interest rates rise and make creditors feel richer — until they realize that prices rose faster than investment income. And firms often prefer to produce later when prices will be higher than they are today.
In short, using monetary expansion is a very risky way to target employment and economic growth. It might work for a short period, but the Fed knows that sustainable increases in the economy are not going to come until the nation’s real problems are dealt with.
The U.S. faces many threats to employment and output. Unfortunately, the more we experiment with expansionary monetary policy, the more we raise the risk of slower growth and divert attention from the real solutions.
1) Trying to make an argument that we should only focus on price stability, "Because everyone else does it, so they must be right," is a pretty weak argument.
2) Mainstream economists are not Keynesian. They are part of the neo-classical synthesis. Arguing with and demonizing a dead man who's ideas mainstream economists only loosely follow is going to get you nowhere fast.
3) Surprise policies definitely freak people out, at least those paying attention (and, arguably, it trickles down to everyone).
4) Quantitative easing WOULD be inflationary...if the financial institutions involved weren't sitting on the money. I'll agree that if confidence and lending picks up, we could be in trouble. That is, if the Fed does nothing. But they have set clear markers ahead of time: They'll end QE when U3 hits 6.5% or core PCE hits 2.5%.
Do I think that's enough? No. They should have rules in place to shrink the monetary base as confidence/lending rises and unemployment falls/inflation rises. Reducing QE purchases, replacing only a fraction of matured bonds, etc.
If we focus on unemployment, could inflation rise? Yes, definitely. We could even pass the 2.5% threshold. But hyperinflation is not right around the corner. There has been no evidence of this and frankly, your argument for why we should be shaking in our boots about it are weak at best, fear-mongering at worst.
We're facing labor market issues (long-term unemployment, possible structural issues, etc.) that monetary policy may not be able to repair alone. And overall, yes, it's extremely important to be critical of Fed policies and keep them accountable. But using hyperinflation fear-mongering is not the way to do it.
P.s. This completely ignores the issue of whether the Fed SHOULD be doing any of this, but that's an argument for another time/place.
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