Inflation Could Help Flagging Economy
Fed should be doing more to reduce joblessness
October 21, 2011
Accusations that the Fed is overstepping its mandate generally imply that it is underweighting the imperative to keep inflation low in favor of trying to lower today's stubbornly high unemployment. This accusation is profoundly misplaced, for three reasons.
First, the idea that high rates of unemployment and inflation demand equal weight in Fed deliberations is bad economics.
Second, even if one granted that unemployment and inflation demand this equal weight, current data still suggests that the Fed should be doing much more to generate lower rates of unemployment.
Third, higher core inflation today would be good, not bad, for the economy.
On the first point, the danger of high unemployment is clear and large—every percentage point of unemployment above the full-employment rate translates into about $260 billion in foregone income in the economy. Take the Congressional Budget Office's conservative estimate of 5.2 percent as the full-employment rate—this implies that today's 9.1 percent unemployment is letting $1 trillion be wasted by failing to do more to drive joblessness down. On the other hand, no serious economic research finds that annual inflation rates below double-digits cause any appreciable harm to economies.
On the second point, a standard monetary policy rule named for Greg Mankiw (former Chair of George W. Bush's Council of Economic Advisors and a Harvard professor) provides equal weight for unemployment and inflation concerns. Even this equal-weight rule indicates that today's 2 perc ent annual core inflation combined with 9.1 percent unemployment should be met with short-term interest rates of negative 1.5 percent - much lower than even today's essentially zero rates. Unfortunately, engineering negative interest rates is impossible, which explains why the Fed has tried unconventional measures (ie, so-called quantitative easing) to provide monetary support to the flagging economy.
On the third point, given the substantial overhang of household debt left by the bursting housing bubble, a bout of higher inflation would actually help the economy by eroding this debt and freeing up consumer spending. This is not a radical suggestion—former International Monetary Fund chief economist Kenneth Rogoff has actually called for higher inflation rates on these grounds.
In short, there's no reason at all to think that the Fed is doing too much to help reduce joblessness—in fact it should be doing much more. And fears about purely hypothetical inflation spikes should not stop them.