The markets applauded Janet Yellen’s report to Congress earlier this week, with stocks, in particular, gaining back a good part of what they had lost since the beginning of 2014. This enthusiasm seems fully justified, as the new Federal Reserve Chair painted an accurate and optimistic picture of both the U.S. economy, which continues to gain strength, and of Fed policy, which is slowly but surely on track to return to normal as the need for extraordinary measures subsides.
In her prepared remarks, Chairwoman Yellen made special note of recently released data that join with others I have written about previously to suggest that the U.S. economy entered the New Year with considerable forward momentum. We now know, for example, that real Gross Domestic Product grew at an annualized rate of more than 3.5 percent in the second half of 2013—that is a very solid number that rivals the best we have seen since the recession of 2007-09. More than half a million jobs were created in the last three months of the year alone, indicating broad-based strength of the kind that has given American businesses the confidence to move forward with hiring and expansion plans.
Against this backdrop of renewed economic vigor, it makes perfect sense for Chair Yellen and her colleagues on the Federal Open Market Committee to continue scaling back on their massive bond-buying programs. It would be a mistake to do otherwise. Given the lags with which monetary policy affects the economy, to delay the tapering any further would raise the risk that inflation, which for now remains below the FOMC’s two percent long-run target, will overshoot that target later, requiring costly corrective measures down the road. Importantly, this strategy of slow-but-steady tapering now reminds us all that the U.S. economy remains on the mend and that FOMC members wish to see monetary policy return to normal as soon as possible.
During the lengthy question-and-answer session that followed her testimony, Chair Yellen acknowledged the surprising weakness in the December and January payroll employment reports but cautioned, quite rightly, against making too much of these latest numbers. For one thing, month-to-month movements in job creation are often erratic, making it desirable to look for clearer trends in averages taken over somewhat longer periods. For another, the unusually harsh winter weather experienced throughout much of the United States has surely disrupted business activity and thereby distorted these figures. Far healthier numbers, on par with if not better than those from the second half of 2013, should start to appear in the spring. For now, the Fed must resist pressure to react to every single data release and remain on the steady course set earlier.
It is difficult to critique a near-perfect performance from someone who is dedicated and patient enough to cheerfully endure what became, quite literally, many hours of questioning from a tough and politicized panel. A small but potentially important opportunity might have been lost, however, for Chair Yellen to emphasize again to members of Congress the importance of the commitment that the FOMC has made to its two percent inflation target. Both economic theory, in the form of the “natural rate hypothesis” developed by Milton Friedman, Edmund Phelps, and Robert Lucas in the late 1960s and early 1970s, and economic history, particularly the episode of high inflation experienced in the United States during the late 1970s, teach us that the Phillips curve, the famous statistical relation associating higher unemployment with lower inflation and vice versa, is too unstable to provide Federal Reserve policymakers with any meaningful trade-off between job gains and price increases. Instead, both theory and experience clearly show that by focusing their efforts on stabilizing inflation first, monetary policymakers also create the preconditions that allow for healthy growth in employment as well.
For now, the Fed’s principal objective has to be to bring inflation, which has run below target for many years now, back to two percent as quickly as possible. Otherwise, persistent, policy-induced deflationary pressures will lead to disappointing job gains as well. But later, if inflation threatens to overshoot to the upside, the Fed will need to act just as aggressively to bring those price increases in check, even if it means a temporary slowdown in growth. Otherwise, persistent inflationary pressures will lead, just as they did during the 1970s, to the worst of both worlds: high inflation and more unemployment. The explicit long-run inflation target, which Chair Yellen helped design, recognizes that the surest way for the Fed to fulfill both sides of its dual mandate is to stabilize prices first and let competitive businesses in free markets create new jobs.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.