Question

4. Can the Fed permanently increase employment? “The Federal Reserve is obsessed with inflation, so much so it ignores the fact that millions of American workers are unemployed. We need a Fed that fights for American jobs. We need a Fed that views any unemployment as too much unemployment, rather than worrying about whether inflation is 2% or 3%.” In a one-page essay, discuss the merits and demerits of this viewpoint, using graphs and equations when helpful.

Answer 1

The Federal Reserve is being stretched thin by the two mandates with which it is charged.

Some central banks, like the European Central Bank, have just one mandate: Keep prices stable. But the Fed has two primary responsibilities: to keep prices stable, and to make sure the nation runs at maximum employment. Our plan sounds better, in theory. After all, who doesn’t want to live in a society where everyone has a job and where the prices you pay for things like food, gas, and medicine never go up? But the actions required to meet those two mandates can be contradictory, and some observers worry we are nearing one of those inflection points today. Their big concern is that by choosing to focus on the still unacceptably high unemployment level in America, the Fed will lose sight of the mandate to fight inflation with disastrous results.

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FEDERAL RESERVE BANK

Fed should focus on inflation, not jobs

By FORTUNE EDITORS April 5, 2011

Ben Bernanke and the Federal Reserve have the authority to curb unemployment. Here’s why they shouldn’t.

FORTUNE — “No one can serve two masters.” So says Jesus in the Bible. And so say a growing number of critics concerned that the Federal Reserve is being stretched thin by the two mandates with which it is charged.

Some central banks, like the European Central Bank, have just one mandate: Keep prices stable. But the Fed has two primary responsibilities: to keep prices stable, and to make sure the nation runs at maximum employment. Our plan sounds better, in theory. After all, who doesn’t want to live in a society where everyone has a job and where the prices you pay for things like food, gas, and medicine never go up? But the actions required to meet those two mandates can be contradictory, and some observers worry we are nearing one of those inflection points today. Their big concern is that by choosing to focus on the still unacceptably high unemployment level in America, the Fed will lose sight of the mandate to fight inflation — with disastrous results.

“The whole thing can backfire,” says John Taylor, an economics professor at Stanford University and an expert on monetary policy. “Inflation starts to run up, you have to stomp on the brakes, then unemployment rises.”

The worst-case scenario? Think back to the 1970s and early 1980s, when inflation skyrocketed, unemployment followed, and the Fed under chairman Paul Volcker had to boost the Federal funds rate as high as 20% to get the situation back under control. Imagine trying to borrow money to buy a house, send a child to college, or start a business with interest rates sitting at 20% or higher, and you begin to get the picture.

What the Fed took away from those difficult years is the fundamental knowledge that — dual mandate or not — the goal of low unemployment had to take a backseat to the goal of fighting inflation. Price stability was understood to be the most important job of the central bank, with the belief that all other aspects of a strong economy would flow from that. And that’s how the Fed operated, not only through Volcker’s time but also through the 18-plus years that Alan Greenspan served as chairman of the Federal Reserve.

It’s a prioritization that Greenspan believes in to this day. “A necessary condition for long-term unemployment is low inflation,” Greenspan said “If the Fed does its job and stabilizes the inflation rate, that’s the maximum that the central bank can do.”

But now even sitting Fed officials worry that this once-unassailable directive could be forgotten. “This crisis has been so large, and it’s taking such a long time to come out of this recession,” frets James Bullard, the president of the St. Louis Federal Reserve Bank, “that it’s upset some of the consensus that was formed in the ’80s, ’90s, and 2000s.”

Benchmark interest rate for the first time in more than nine years. Arguing in favour of a hike is the low unemployment rate, which fell to 5.1% in August. Arguing against it is the rate of inflation which, having come in at 0.3% year-on-year in July, is well below the 2% target that is the lodestar of Fed policy. But why does the Fed want 2% inflation in the first place?

Central banks are responsible for monetary policy: roughly speaking, the job of controlling the amount of money that courses through the economy. For a long time, monetary policy consisted of little more than stabilisation of the exchange rate, which was often fixed (eg by the gold standard at the beginning of the 20th century) in order to facilitate international commerce. But exchange rates proved a poor target for policymakers. Pulling money out of the economy to buoy the currency and protect the exchange rate could send the economy into a tailspin; such policies helped create the Depression of the 1930s.

After the Depression governments prioritised domestic employment. Central banks reckoned the economy followed a relationship known as the Phillips curve, which posits a trade-off between inflation and unemployment; governments could have less of one if they were prepared to accept more of the other. Yet amid the "stagflation" of the 1970s, an unholy mixture of economic stagnation with inflation, economists realised that this relationship weakened over time, as people figured out what was going on and revised their expectations for future inflation. The stimulative effect of faster price growth faded, leaving economies with both high inflation and high unemployment. Economists realised the best a central bank could do to boost long-run growth was to make the path of policy clear and predictable to the public.

To do that, central banks needed to select an economic variable to set as a target: one linked to the health of the economy and over which the central bank could exercise some control. A clear, public target would keep central banks disciplined and help stabilise the economy (markets would anticipate easier policy when the economy looked like it was falling short of the target, for instance, and increased spending and investment would therefore help the central bank push the economy back on the right course). Milton Friedman, a Nobel-prize-winning economist, reckoned central banks should aim for growth in the money supply. Central banks tried that for a while, but found that when they made money growth their target the relationship between it and the health of the economy broke down, just as the Phillips curve had. Many then settled on an inflation target. Inflation was readily observable and, it was thought, was a reliable thermostat for an economy. The central bank of New Zealand was the first to adopt an inflation target, in 1990. The Fed pursued an unofficial inflation target over a long period, only making its policy official in January of 2012, when it announced that it thought a policy which targets a 2% rate of inflation "is most consistent over the longer run with the Federal Reserve's statutory mandate".

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The Economist explains

The Economist explains

Why the Fed targets 2% inflation

The Economist explains

Sep 13th 2015by R.A.

ON SEPTEMBER 17th the Federal Reserve will conclude a two-day, rate-setting meeting at which it just might raise its benchmark interest rate for the first time in more than nine years. Arguing in favour of a hike is the low unemployment rate, which fell to 5.1% in August. Arguing against it is the rate of inflation which, having come in at 0.3% year-on-year in July, is well below the 2% target that is the lodestar of Fed policy. But why does the Fed want 2% inflation in the first place?

Central banks are responsible for monetary policy: roughly speaking, the job of controlling the amount of money that courses through the economy. For a long time, monetary policy consisted of little more than stabilisation of the exchange rate, which was often fixed (eg by the gold standard at the beginning of the 20th century) in order to facilitate international commerce. But exchange rates proved a poor target for policymakers. Pulling money out of the economy to buoy the currency and protect the exchange rate could send the economy into a tailspin; such policies helped create the Depression of the 1930s.

After the Depression governments prioritised domestic employment. Central banks reckoned the economy followed a relationship known as the Phillips curve, which posits a trade-off between inflation and unemployment; governments could have less of one if they were prepared to accept more of the other. Yet amid the "stagflation" of the 1970s, an unholy mixture of economic stagnation with inflation, economists realised that this relationship weakened over time, as people figured out what was going on and revised their expectations for future inflation. The stimulative effect of faster price growth faded, leaving economies with both high inflation and high unemployment. Economists realised the best a central bank could do to boost long-run growth was to make the path of policy clear and predictable to the public.

To do that, central banks needed to select an economic variable to set as a target: one linked to the health of the economy and over which the central bank could exercise some control. A clear, public target would keep central banks disciplined and help stabilise the economy (markets would anticipate easier policy when the economy looked like it was falling short of the target, for instance, and increased spending and investment would therefore help the central bank push the economy back on the right course). Milton Friedman, a Nobel-prize-winning economist, reckoned central banks should aim for growth in the money supply. Central banks tried that for a while, but found that when they made money growth their target the relationship between it and the health of the economy broke down, just as the Phillips curve had. Many then settled on an inflation target. Inflation was readily observable and, it was thought, was a reliable thermostat for an economy. The central bank of New Zealand was the first to adopt an inflation target, in 1990. The Fed pursued an unofficial inflation target over a long period, only making its policy official in January of 2012, when it announced that it thought a policy which targets a 2% rate of inflation "is most consistent over the longer run with the Federal Reserve's statutory mandate".

The Fed should wait until inflation is higher to raise its interest rate why 2%? A higher inflation rate is costlier, in economic terms, than a lower one. Higher inflation is often more volatile inflation, and since some prices adjust more easily than others, a higher inflation rate can generate distortions in the economy as relative prices fall off-kilter. But low inflation is not without its risks. Firms find it hard to cut wages in many cases—like when a recession strikes, reducing the demand for workers. But if inflation is high, then the real cost of labour can fall even if actual wages don't (because workers become cheaper relative to the goods they are producing), so firms face less pressure to sack workers in a downturn. Moreover, a lower inflation rate corresponds to lower interest rates (since creditors demand an inflation premium when lending over longer periods of time). When interest rates are very low, odds increase that a central bank might have to reduce its benchmark interest rate all the way to zero to fend off economic weakness. Since central banks can't easily reduce their interest rates below zero, low inflation effectively boosts the chances that a central bank will become relatively helpless in the face of a nasty recession.

In the early 1990s, when many central banks were deciding what rate to pick as their target, it was assumed that this "zero lower bound" would only rarely become a problem at a 2% rate of inflation. That judgment, as it turns out, was wrong. Just a few decades later, most of the rich world is stuck with interest rates close to or even below zero, and with inflation rates well below official targets. Whatever the Fed decides to do this week, it appears that central banks may need to change their targets once again, and soon.

a bit of inflation would be good for the economy, raising employment in particular. The data show the opposite cause and effect, however. The figure plots the civilian unemployment rate and the inflation rate, which is calculated as the annual percentage change in the all- items Consumer Price Index.