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2014-12-15 15:08:58
Dec 5th 2014, 21:13 by G.I. | WASHINGTON, D.C.
Sometime next year, the Federal Reserve will likely face an unusual confluence
of economic circumstances. One of its mandates, full employment, will call for
monetary policy to tighten relatively quickly; the other, inflation, will
suggest it should stay loose. How should the Fed weigh these competing goals?
It may want to dust off a doctrine from the 1990s, opportunistic disinflation
and rechristen it "opportunistic inflation.
The impressive pace of job creation reported today underlined the approaching
crunch point. The number of new non-farm jobs in November, at 321,000, was the
most in nearly three years. Along with revisions of 44,000 to prior months, it
shows this year s already-solid pace is accelerating. The unemployment rate
remained at 5.8%, but if this year s combination of job and labour force growth
continue, it will drop below 5% within a year, easily undershooting the Fed s
estimate of its natural rate. True, the current unemployment rate may overstate
how strong the labuor market is, but other measures suggest slack is quickly
disappearing: the broader U-6 measure of underemployment dropped to 11.4% in
November, from 11.5%, long-term unemployment edged down to 1.8% from 1.9%, and
involuntary part time work declined.
But even as the Fed hits its full-employment target, it will be badly missing
on its 2% inflation target from below. Headline inflation was 1.7% in
October, and core inflation, according to the Fed s preferred index, was just
1.5%. Petrol prices have plunged further since, so headline inflation is likely
headed below 1%, and pass-through effects will likely push core further down as
well.
The view inside the Fed is that this undershoot is temporary and over the next
few years, a strengthening economy and inflation expectations will tug
inflation back to target. They shouldn't be so sure. The fall in the oil price
is a mixed blessing. It will generate a powerful lift to consumption and
employment in the next six months, and indeed may already have, given the
strength of retail employment. But, along with the rise in the dollar and the
fall in other commodity prices, it will keep inflation below target for several
years. Inflation has already persisted below target longer than the Fed
expected, and the latest data suggest that it is the public's expectations of
inflation that are converging towards actual inflation, rather than the other
way around.
This makes it all the more likely that expectations, and thus actual inflation,
will become entrenched below target. Against a backdrop of full employment,
this may seem acceptable. It isn t. Too-low inflation means that the next time
the economy falls into recession, interest rates will once again probably fall
to zero, which may be too high in real terms to adequately restore growth. The
risk, then, is that inflation grinds even further below target.
While the circumstances facing the Fed may be novel, the tactical challenge is
not. Two decades ago, inflation was above any reasonable definition of price
stability. In contemplating how to get it lower, Fed officials came up with the
moniker of opportunistic disinflation. The Fed would not deliberately push
the economy into recession, but it would exploit the inevitable recessions and
resulting output gaps that came along to nudge inflation closer to target. In
1996 then governor Laurence Meyer defined it thus:
Under this strategy, once inflation becomes modest, as today, Federal Reserve
policy in the near term focuses on sustaining trend growth at full employment
at the prevailing inflation rate. At this point the short-run priorities are
twofold: sustaining the expansion and preventing an acceleration of inflation.
This is, nevertheless, a strategy for disinflation because it takes advantage
of the opportunity of inevitable recessions and potential positive supply
shocks to ratchet down inflation over time.
The strategy succeeded: after the recession of 2001, inflation fell to 2% and
stayed there.
Today's mirror image would be opportunistic inflation : exploit any
overheating in the economy as an opportunity to push inflation higher. If
unemployment does fall to 5% next year, that should have two beneficial effects
for the labour market. First, it should push up wages. Hourly earnings rose
0.4% in November, an unexpectedly brisk and long overdue increase. But they are
still up just 2.1% from a year earlier. Since profit margins are so wide, it
will take several years of stronger wage growth to generate cost-push
inflation. Second, some of the long-term unemployed who have quit the labour
force should be drawn back in, reversing some of the loss of potential output
brought about by the prolonged period the economy spent depressed.
To get inflation higher requires a negative output gap by allowing unemployment
to fall below its natural rate for a time. That may happen even on the current
plan in which interest rates start to rise slowly from zero in 2015. If so, the
Fed should simply let it happen. It may want to encourage the process by
delaying the normalization of rates, or stretching it out over more months.
This is not without pitfalls; inflation could take off more quickly than
expected, or financial imbalances could worsen. On the other hand, inflation
may stay dormant for longer, and the Fed will then conclude the natural rate of
unemployment is actually lower than 5%; and it will have been glad not to have
tightened too soon.