Yellen’s Fed Might Be Feeling Deja Vu
Unemployment was headed lower. While consumer-price gauges remained steady, a Federal Reserve official warned that the U.S. economy was “operating in an inflationary danger zone” that justified raising interest rates.
That
was September 1996.
The Fed today faces a similar conundrum and the official who was pressing for a
rate increase 19 years ago—then board governor Janet Yellen--is now the central
bank’s powerful chairwoman.
In
theory, when unemployment falls low enough and the labor market tightens, wage
and price growth accelerates. Ms. Yellen has long cited the so-called Phillips
curve describing that relationship as a framework for understanding the economy
and the Fed’s looming decision on when to raise short-term interest rates that
have been pinned near zero for nearly seven years. “An important factor working
to increase my confidence in the inflation outlook will be continued
improvement in the labor market,” she said in
March. “A substantial body of theory, informed by considerable
historical evidence, suggests that inflation will eventually begin to rise as
resource utilization continues to tighten.”
But
the Phillips curve’s shortcomings – the relationship between slack and
inflation shifts over time and has become increasingly elusive in U.S. data --
limit its practical
use as a tool to predict the future or fine-tune monetary
policy. If the U.S. labor market is approaching full health, why are price
inflation and wage growth still so low? That uncertainty is weighing on policy
makers ahead of the Fed’s Sept. 16-17 meeting. At their July meeting, several
Fed officials “noted that higher rates of resource utilization appeared to have
had only very limited effects to date on wages and prices, and underscored the
uncertainty surrounding the inflation process as well as the role and dynamics
of inflation expectations,” according to minutes released last
week.
The
Fed’s experience in the mid-1990s offers interesting parallels. Then, as now,
falling unemployment with little response from inflation left the Fed less
certain about the economy’s capacity. Then, as now, the central bank revised
down estimates for the level of unemployment at which inflation pressures emerge in
earnest.
A
key difference is that two decades ago, Chairman Alan Greenspan’s Fed came to
realize a surge in labor productivity was temporarily allowing joblessness to
fall without stoking higher inflation. Today, productivity growth has flatlined.
Some
forces may be temporarily holding down inflation now, such as the strong dollar
and low oil prices. But if the economy remains on track and slack in the labor
market continues to shrink, price growth should eventually accelerate. Because
monetary policy operates with long lags, the Fed will have to raise interest
rates to keep inflation in check.
At least, that seems to be the Fed’s theory. We’ll find out in a few
weeks if it’s convinced enough to act on it.
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