Martin Wolf: The Fed is treading a fine line on monetary tightening

If a big jump in inflation would be destructive, so would excessive tightening

Fed chairwoman Janet Yellen: she has  demonstrated why she is, of the known candidates for next Fed chairman, the outstanding one. Photograph: Reuters/Joshua Roberts

Fed chairwoman Janet Yellen: she has demonstrated why she is, of the known candidates for next Fed chairman, the outstanding one. Photograph: Reuters/Joshua Roberts

 

Is a surge in inflation a significant threat to sustained recovery? The likely answer is no. But the proposition is no longer absurd, as it was when Kevin Warsh, then a governor of the Federal Reserve and now a candidate for chairman, stated in March 2010 that “I don’t think we should be complacent about inflation risk”. That misjudgment should rule out his candidacy.

Yet times have changed. This explains the Fed’s commitment to gradual monetary tightening.

The European Central Bank is planning to withdraw stimulus. The question is whether this tightening cycle will be smooth or bumpy. Inflation would make the difference.

Even a broken clock will be right twice a day. Austrian economists and goldbugs have warned of an imminent upsurge in inflation for years. Maybe they will be right – at last.

The consequences would be highly disruptive. If inflation rose really rapidly, monetary policy would have to tighten significantly. That would trigger fears of a recession. Moreover, even if long-term real interest rates did not rise, risk premia on inflation, expected future short-term interest rates and the uncertainty surrounding those expected future rates would all jump, raising yields on conventional bonds substantially.

All this would undermine elevated asset markets and might trigger worries over debt sustainability. In a still fragile world economy the results might be ugly. One might even see a return to the stagflation of the 1970s, with far lower inflation but also far higher indebtedness.

The focus of attention is on the Fed. The US is still the world’s most important economy, and the Fed the most important central bank. The US is also far more advanced in its return to normal economic conditions than other large, high-income economies.

Next chairman

In a lucid recent speech Janet Yellen laid out the issues. She also demonstrated why she is, of known candidates for next chairman, the outstanding one. Donald Trump would only choose one of the others if he were as determined to destroy the Fed as he is to ruin the state department and other agencies.

The starting point is a puzzle: why is inflation so low when the rate of unemployment is already a little below the level the Fed (and most economists) consider to be “full employment” (the rate at which inflation should start to accelerate upwards).

The Fed’s analysis suggests that labour market slack is no longer an important downward factor, while a series of temporary downward shocks are also now in the past. So, the Fed believes, inflation will soon move back towards its target.

Why might this view be wrong?

One possibility is that more labour market slack still exists than the unemployment rate suggests. The ratio of employment to population for those aged 25 to 54 is still well below previous cyclical peaks. The rate of part-time employment is also somewhat elevated.

A thorough study by the International Monetary Fund in its latest World Economic Outlook notes broadly that “while involuntary part-time employment may have helped support labour force participation and facilitated stronger engagement with the workplace than the alternative of unemployment, it also appears to have weakened wage growth”.

Yet most other measures of labour market pressure are back to pre-recession levels. So even if US wage growth is well contained, this might not last.

Inflation expectations

Another factor is inflation expectations. This cuts two ways. At the moment those expectations are well anchored, the only big worry being a decline in market expectations of inflation (or inflation risk) more than five years hence. Such expectations might feed into behaviour, generating a self-fulfilling prophecy of low inflation.

This would counteract the symptoms of the labour market pressure. At some point, however, the latter could boil over into rapidly rising wages, probably at rates well above those consistent with stable inflation. We have seen that before.

At present, however, the risks do not seem that great. But, as always, this is a matter of risk management. We can have little doubt that a substantial rise in inflation above target would create significant danger. Raising the target in such a situation would certainly destroy confidence in the Fed.

Yet trying to hit the target could, for reasons indicated above, be destructive, possibly tipping the US back into a recession from which it would be hard to exit. This would be particularly true if the damage to asset price effects was large and much bad debt re-emerged. Yet under this scenario short-term interest rates would at least have to rise substantially, giving the Fed more room to cut than it has now.

If a big jump in inflation would be destructive, so would premature, or excessive, tightening. That could further lower inflation, destabilising expectations further. It might weaken the economy so much that, given still limited room to cut interest rates without going into negative territory, it would be difficult to restore demand without going into negative territory.

Hugely desirable

Above all, after the huge and politically destabilising shock of the Great Recession, a lengthy period of strong labour markets would be hugely desirable, even healing.

The Fed has to balance between tightening too fast and too slowly. Nobody can be sure it is now wrong. My best guess is that an explosive rise in inflation is highly unlikely. The Fed can afford to take its time, while testing the capacity of the US economy to expand supply.

But risks are real on both sides. The Fed has probably been right to tighten a little. But it must be careful not to go too far. It has earned much credibility over inflation. Sometimes what one has earned should be spent. This is just such a time. – Copyright The Financial Times Limited 2017

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