4. Can the Fed permanently inc

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

Some central banks, like the European Central Bank, have justone mandate: Keep prices stable. But the Fed has two primaryresponsibilities: to keep prices stable, and to make sure thenation runs at maximum employment. Our plan sounds better, intheory. After all, who doesn’t want to live in a society whereeveryone has a job and where the prices you pay for things likefood, gas, and medicine never go up? But the actions required tomeet those two mandates can be contradictory, and some observersworry we are nearing one of those inflection points today. Theirbig concern is that by choosing to focus on the still unacceptablyhigh unemployment level in America, the Fed will lose sight of themandate 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 curbunemployment. Here’s why they shouldn’t.

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

Some central banks, like the European Central Bank, have justone mandate: Keep prices stable. But the Fed has two primaryresponsibilities: to keep prices stable, and to make sure thenation runs at maximum employment. Our plan sounds better, intheory. After all, who doesn’t want to live in a society whereeveryone has a job and where the prices you pay for things likefood, gas, and medicine never go up? But the actions required tomeet those two mandates can be contradictory, and some observersworry we are nearing one of those inflection points today. Theirbig concern is that by choosing to focus on the still unacceptablyhigh unemployment level in America, the Fed will lose sight of themandate to fight inflation — with disastrous results.

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

The worst-case scenario? Think back to the 1970s and early1980s, when inflation skyrocketed, unemployment followed, and theFed under chairman Paul Volcker had to boost the Federal funds rateas high as 20% to get the situation back under control. Imaginetrying to borrow money to buy a house, send a child to college, orstart a business with interest rates sitting at 20% or higher, andyou begin to get the picture.

What the Fed took away from those difficult years is thefundamental knowledge that — dual mandate or not — the goal of lowunemployment had to take a backseat to the goal of fightinginflation. Price stability was understood to be the most importantjob of the central bank, with the belief that all other aspects ofa strong economy would flow from that. And that’s how the Fedoperated, not only through Volcker’s time but also through the18-plus years that Alan Greenspan served as chairman of the FederalReserve.

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

But now even sitting Fed officials worry that thisonce-unassailable directive could be forgotten. “This crisis hasbeen so large, and it’s taking such a long time to come out of thisrecession,” frets James Bullard, the president of the St. LouisFederal Reserve Bank, “that it’s upset some of the consensus thatwas formed in the ’80s, ’90s, and 2000s.”

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

Central banks are responsible for monetary policy: roughlyspeaking, the job of controlling the amount of money that coursesthrough the economy. For a long time, monetary policy consisted oflittle more than stabilisation of the exchange rate, which wasoften fixed (eg by the gold standard at the beginning of the 20thcentury) in order to facilitate international commerce. Butexchange rates proved a poor target for policymakers. Pulling moneyout of the economy to buoy the currency and protect the exchangerate could send the economy into a tailspin; such policies helpedcreate the Depression of the 1930s.

After the Depression governments prioritised domesticemployment. Central banks reckoned the economy followed arelationship known as the Phillips curve, which posits a trade-offbetween inflation and unemployment; governments could have less ofone if they were prepared to accept more of the other. Yet amid the”stagflation” of the 1970s, an unholy mixture of economicstagnation with inflation, economists realised that thisrelationship weakened over time, as people figured out what wasgoing on and revised their expectations for future inflation. Thestimulative effect of faster price growth faded, leaving economieswith both high inflation and high unemployment. Economists realisedthe best a central bank could do to boost long-run growth was tomake the path of policy clear and predictable to the public.

To do that, central banks needed to select an economic variableto set as a target: one linked to the health of the economy andover which the central bank could exercise some control. A clear,public target would keep central banks disciplined and helpstabilise the economy (markets would anticipate easier policy whenthe economy looked like it was falling short of the target, forinstance, and increased spending and investment would thereforehelp the central bank push the economy back on the right course).Milton Friedman, a Nobel-prize-winning economist, reckoned centralbanks should aim for growth in the money supply. Central bankstried that for a while, but found that when they made money growththeir target the relationship between it and the health of theeconomy broke down, just as the Phillips curve had. Many thensettled on an inflation target. Inflation was readily observableand, it was thought, was a reliable thermostat for an economy. Thecentral bank of New Zealand was the first to adopt an inflationtarget, in 1990. The Fed pursued an unofficial inflation targetover a long period, only making its policy official in January of2012, when it announced that it thought a policy which targets a 2%rate of inflation “is most consistent over the longer run with theFederal 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 benchmarkinterest rate for the first time in more than nine years. Arguingin favour of a hike is the low unemployment rate, which fell to5.1% 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 Fedwant 2% inflation in the first place?

Central banks are responsible for monetary policy: roughlyspeaking, the job of controlling the amount of money that coursesthrough the economy. For a long time, monetary policy consisted oflittle more than stabilisation of the exchange rate, which wasoften fixed (eg by the gold standard at the beginning of the 20thcentury) in order to facilitate international commerce. Butexchange rates proved a poor target for policymakers. Pulling moneyout of the economy to buoy the currency and protect the exchangerate could send the economy into a tailspin; such policies helpedcreate the Depression of the 1930s.

After the Depression governments prioritised domesticemployment. Central banks reckoned the economy followed arelationship known as the Phillips curve, which posits a trade-offbetween inflation and unemployment; governments could have less ofone if they were prepared to accept more of the other. Yet amid the”stagflation” of the 1970s, an unholy mixture of economicstagnation with inflation, economists realised that thisrelationship weakened over time, as people figured out what wasgoing on and revised their expectations for future inflation. Thestimulative effect of faster price growth faded, leaving economieswith both high inflation and high unemployment. Economists realisedthe best a central bank could do to boost long-run growth was tomake the path of policy clear and predictable to the public.

To do that, central banks needed to select an economic variableto set as a target: one linked to the health of the economy andover which the central bank could exercise some control. A clear,public target would keep central banks disciplined and helpstabilise the economy (markets would anticipate easier policy whenthe economy looked like it was falling short of the target, forinstance, and increased spending and investment would thereforehelp the central bank push the economy back on the right course).Milton Friedman, a Nobel-prize-winning economist, reckoned centralbanks should aim for growth in the money supply. Central bankstried that for a while, but found that when they made money growththeir target the relationship between it and the health of theeconomy broke down, just as the Phillips curve had. Many thensettled on an inflation target. Inflation was readily observableand, it was thought, was a reliable thermostat for an economy. Thecentral bank of New Zealand was the first to adopt an inflationtarget, in 1990. The Fed pursued an unofficial inflation targetover a long period, only making its policy official in January of2012, when it announced that it thought a policy which targets a 2%rate of inflation “is most consistent over the longer run with theFederal Reserve’s statutory mandate”.

The Fed should wait until inflation is higher to raise itsinterest rate why 2%? A higher inflation rate is costlier, ineconomic terms, than a lower one. Higher inflation is often morevolatile inflation, and since some prices adjust more easily thanothers, a higher inflation rate can generate distortions in theeconomy as relative prices fall off-kilter. But low inflation isnot without its risks. Firms find it hard to cut wages in manycases—like when a recession strikes, reducing the demand forworkers. But if inflation is high, then the real cost of labour canfall even if actual wages don’t (because workers become cheaperrelative to the goods they are producing), so firms face lesspressure to sack workers in a downturn. Moreover, a lower inflationrate corresponds to lower interest rates (since creditors demand aninflation premium when lending over longer periods of time). Wheninterest rates are very low, odds increase that a central bankmight have to reduce its benchmark interest rate all the way tozero to fend off economic weakness. Since central banks can’teasily reduce their interest rates below zero, low inflationeffectively boosts the chances that a central bank will becomerelatively helpless in the face of a nasty recession.

In the early 1990s, when many central banks were deciding whatrate to pick as their target, it was assumed that this “zero lowerbound” would only rarely become a problem at a 2% rate ofinflation. That judgment, as it turns out, was wrong. Just a fewdecades later, most of the rich world is stuck with interest ratesclose to or even below zero, and with inflation rates well belowofficial targets. Whatever the Fed decides to do this week, itappears that central banks may need to change their targets onceagain, and soon.

a bit of inflation would be good for the economy, raisingemployment in particular. The data show the opposite cause andeffect, however. The figure plots the civilian unemployment rateand the inflation rate, which is calculated as the annualpercentage change in the all- items Consumer Price Index.

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