Recovery Delayed is Recovery Lost: Inflation vs. Unemployment

The U.S. economy continues to sputter along and the Federal Reserve apparently unable (or perhaps more accurately, unwilling) to do much about it. Unemployment in the United States continues to hover above 10 percent, and in some regions of the country it is much higher: Michigan has 14.7 percent unemployment, Rhode Island 12.7 percent, and South Carolina, Florida, and Nevada are all at 12.3 percent.

As the U.S. economy continues to struggle, Federal Reserve Chair Ben Bernanke was testifying before Congress to be reappointed to his position. Several prominent economists offered their questions for Bernanke via the Real Time Economics blog at the Wall Street Journal. The one question that has generated the most discussion was posed by Brad Delong, who wanted to know why the Fed continues to maintain a zero-tolerance policy towards inflation rather than adopting the 3 percent inflation target accepted by some countries. Bernanke’s answer has received a great deal of attention. According to Bernanke,

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

Given that inflation and unemployment are inversely related (as one goes up, the other generally goes down), keeping inflation near zero means accepting higher rates of unemployment. Conversely, addressing the challenge of unemployment would mean living with slightly higher rates of inflation. The Fed’s insistence on keeping inflation near zero this means that we have to accept higher rates of unemployment during the economic downturn. And thus the debate.

According to Ryan Avent at the Economist’s Free Exchange blog,

Personally, I think that Mr Bernanke owes us all a better explanation of why he has opted to place so much more emphasis on the price stability aspect of his mission than the full employment aspect. And, there should be a policy debate on this question, the resolution of which should inform the choice to reappoint (or not) Mr Bernanke. But that’s clearly not going to happen. It’s unfortunate. But it is what it is. Best to focus on the next question—how to minimise the fall-out from five or more years of high unemployment.

Paul Krugman concurs, observing

Future economic historians will, I believe, see this as fundamentally absurd — as absurd as the inflation fears that paralyzed the Bank of England in the early 1930s even as the world went into a deflationary spiral. Yes, there may someday be a 1970s-type episode in which the Fed needs to fight inflation, not encourage it — but it’s a long way off. Furthermore, why on earth would we imagine that the Bernanke Fed, by showing itself willing to inflict gratuitous pain in 2010, would make it easier for whoever is running the Fed in, say, 2020 to control inflation then, let alone that the tradeoff of real pain now versus hypothetical pain much later, if it even exists, is worth making? Anyway, as far as I can see nobody is even trying to assess these alleged tradeoffs seriously. Instead, the notion of an unchanging inflation target — not to be revised even in the face of the worst slump since the Depression — has acquired a sort of mystical force; it has become identified with the notion of Civilization, in much the way that a previous generation assigned mystic significance to the gold standard.

Not much of a silver lining there.

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