Our inflationary trajectory looks increasingly bleak, and recession fears are intensifying. Commentators fear that the only way the Federal Reserve can control rising prices is by dismal performance and employment. Monetary policy makers seem willing to bear the economic cost if that means curbing inflation. How Wall Street JournalNick Timiraos writes“Central bankers believe that when unemployment falls below a certain natural equilibrium level, a tight labor market puts upward pressure on wages and prices.”
The trade-off between unemployment and inflation is an old idea in economics. Many politicians, journalists and intellectuals believe in this. But they are wrong. Compromise is an illusion. The persistence of this erroneous belief is nothing but zombie economy. If central banks are doing their job, there is no connection between unemployment and inflation. It only seems that we are faced with a choice if they behave irresponsibly.
Imagine the Fed clearly and credibly adhering to the results-based principle. nominal anchor— A variable expressed in current dollars that makes the central bank’s promises concrete. For example, suppose the Fed has set a strict inflation target of 2 percent. With the Fed building a solid foundation, markets can allocate resources to the most important areas, ensuring that unemployment is as low as possible on a sustainable basis.
there is nothing special in 2 percent inflation. It might as well be 3 or 5 percent. It might even be slightly negative. Most importantly, household and business plans are in line with Fed policy. Given a nominal anchor, households and businesses will include expected inflation in their bid and ask prices, with employment driven by supply-side factors. These include the availability of capital and natural resources, the efficiency of technology, and the quality of laws and institutions. Some unemployment will remain, of course, because it is difficult for workers to find suitable jobs and for businesses to find suitable assistance. But this minimum sustainable unemployment rate, sometimes referred to as natural rate unemployment is consistent with the entire range of inflation rates. There is no compromise.
What if the Fed is not trustworthy? Perhaps the markets have good reason not to trust the Fed. For example, the Fed may try to fool the markets by promising 2 percent inflation and then exceeding it. In the short term, unexpectedly easy money shakes up production. workers work overtime; machines run faster; stocks are shrinking. But this only lasts until market participants understand the game. Once they know the Fed’s policy is inconsistent with 2 percent inflation, they start replacing those quantitative adjustments with price adjustments. The workers demand higher nominal wages. Business demands higher nominal prices. The end result is higher inflation than the Fed promised.
In the short term, it may seem that lower unemployment goes hand in hand with higher inflation. The compromise seems real. But these are not significant economic relations. This has nothing to do with the structure of a market economy. On the contrary, it is solely due to the fact that the Fed says one thing and does another. Intended relationships cannot be reliably used, and if they are used, they are not for long. Unemployment eventually returns to whatever level is in line with the fundamentals of the economy. The only result is a permanent depreciation of the dollar beyond the guidance of the Fed.
This is why inflation expectations are so important. Monetary policy makers have known for decades that household and business inflation expectations are critical determinants of economic health. Ultimately, inflation expectations depend on the credibility of the Fed. If a credible Fed promises 2% inflation, markets expect 2% inflation. If the incredible Fed promises 2% inflation, markets can expect anything. Arbitrary monetary policy is the reason that inflation expectations have become “unanchored”. If the Fed has to hurt the markets now to restore its credibility, it’s only because central banks eroded that credibility in the first place.
Why did the Fed lose confidence? We know that monetary policy has been too loose for the last year. That’s a big part of it. But the Fed’s decision to change the long-term goal of monetary policy in August 2020 also contributed.
From January 2012 to August 2020, the Fed allegedly stuck to its inflation target of 2 percent. With inflation generally below 2 percent for the period, markets began to interpret the Fed’s 2 percent inflation target as 2 percent. ceiling. This is not good for credibility, but at least the range of policy outcomes (between 0 and 2 percent) was small. In practice, the 2 percent ceiling met the target of about 1.7 percent.
In August 2020, the Fed accepted average inflation target. The goal was to average 2 percent inflation over many years, not about (or no more than) 2 percent a year. In hindsight, this seems to have raised the effective target considerably and created a lot of trust issues.
For markets to believe the Fed’s new policy, the target must be symmetric. If inflation is too low this year, the Fed should allow inflation above its target next year. But it works both ways: if inflation is too high this year, the Fed should allow inflation below its target next year. However, in reality, the Fed will never allow deflation. It also seems to be no longer willing to tolerate inflation below 2 percent, even if it needs to reach an average of 2 percent. Inflation ceiling became inflation floor. Instead of expecting slightly less than 2%, markets have begun to expect more than 2%, and potentially much more.
If a target is not symmetrical (and markets obviously don’t), this rule will not anchor inflation expectations very well. Expected inflation is higher and its dispersion is larger than under a symmetrical average inflation target. The Fed says it will deliver 2 percent inflation, but the actual operation of its asymmetric average inflation target virtually guarantees that won’t happen. Markets seem to understood it.
It all depends on credibility. Now that the Fed lost itperhaps only a painful reduction in aggregate demand can bring it back. But that doesn’t mean that lower inflation in exchange for higher unemployment is a permanent policy option. Due to the mistakes of the past years, unemployment will rise. Our only “choice” now is whether this will be accompanied by high or low inflation.
Every time there seems to be a compromise between unemployment and inflation, something has gone wrong. We could avoid both horns of the dilemma if the Fed did its job.