Unemployment has fallen to 5.1 percent, much closer to its past cyclical lows than its peak of 10 percent reached in October 2009. Yet inflation remains stubbornly slow. The price index for core consumer expenditures has risen only 1.25 percent over the past 12 months!
These data present the Federal Reserve with a dilemma. The Fed appears to have delivered an outcome consistent with one side of its dual mandate, by promoting maximum sustainable employment, while falling well short on the other, by allowing inflation to run persistently below target. These data also confront macroeconomists with a puzzle. The Phillips curve relation between unemployment and inflation, a basic building block of every mainstream model, seems to have broken down. With unemployment so low, why isn’t inflation higher? And with inflation so low, why should the Fed raise interest rates?
To answer these questions, it helps to acknowledge, first, that the current bout of Phillips curve instability is by no means unprecedented. Throughout the 1970s, for example, unemployment trended higher, and inflation did too. Partly, this recurring instability reflects a more basic fact: that the unemployment rate is affected, not only by monetary policy, but by a host of non-monetary factors as well. Robert Shimer’s analysis, for instance, attributes much of the rise in unemployment during the 1970s to demographic changes, as younger workers, who are always more likely to suffer from jobless spells, entered the labor market en masse. In addition, whereas inflation in the long run is well described by Milton Friedman as “always and everywhere a monetary phenomenon,” it can, over shorter horizons, be influenced by changing prices of imported goods. In particular, while rising oil prices in the 1970s were not the principal factor driving inflation’s upward trend, they certainly account for the transitory spikes that followed the supply shocks of 1974 and 1979. Today, equally profound demographic shifts are affecting unemployment in ways that no one understands, while volatile commodity prices are again distorting measures of inflation. Perhaps it’s not so surprising that recent forecasts based on Phillips curves have badly missed their mark.
If the Fed cannot rely on a stable Phillips curve to guide its policies, what other options does it have? The Fed could simply wait, keeping interest rates low until inflation moves closer to, or even rises above, its 2 percent target. Yet this approach raises significant risks of its own. No one is sure how much influence the declining price of oil and rising foreign exchange value of the dollar are having on measured inflation. But when the transient effects of these relative price movements wear off, inflation will jump higher. If the Fed then appears to have fallen behind the curve in its efforts to control inflation, policy rates will have to be raised much more vigorously, putting the economic expansion in jeopardy. Modest rate increases, starting now, would help guard against these risks.
The case for action is buttressed further by recent data on money growth. Like Phillips curves, money demand equations exhibit periodic instability, making them difficult to use, by themselves, in forecasting inflation. Precisely because no one model is fully reliable, however, an eclectic approach is called for. The broad MZM monetary aggregate, in both its simple-sum and Divisia form, has grown at rates exceeding 6 percent per year extending back to mid-2011. Thus, a quantity theoretic view confirms that monetary policy is providing ample support for a rebound in inflation back to target.
Some Federal Reserve officials worry about the risks of tightening too quickly, as in retrospect they appear to have done in early 2010 when bringing the first round of quantitative easing to a close. Monitoring money can help guard against this risk, too. In 2010, MZM growth plummeted, even turning negative, reflecting outright monetary contraction. If broad money growth starts to show similar signs of marked deceleration after an initial rate hike, that would be a clear signal that the Fed needs to slow down, or even reverse course and provide additional stimulus.
Looking back to 2010 reminds us that monetary policy decisions must always be made under uncertainty, and that risks are always present. After four years of solid money growth, however, the greatest risks are those of delayed action that would cause inflation to overshoot its target and require a costly correction later on. The Fed needs to being raising rates now, to bring inflation smoothly back to target. As it does so, observations of broad monetary aggregates can be used to check that policy remains on track.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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