The US Fed currently have an interesting problem which other central bank would be happy to have. They have a dual mandate of Price Stability – 2% inflation and Full Employment – 5% unemployment. The current unemployment rate is 5.8%, the lowest level since 2008, and if it drops below 5% there could be labour shortages which will help to put pressure on wages and ultimately inflation. However the current inflation rate is only 1.3% and it is heading below 1% next year. There are two main reasons for this:
* The significant drop oil prices and
* A stronger US$ making imports cheaper
The concern for the US Fed is that inflation over the next couple of years stays well below the 2% threshold and interest rates remain close to 0%. As pointed out by The Economist the problem will be when the next recession rears its ugly head and Fed has no room to cut rates further as they cannot fall below 0%, since savers would simply convert their deposits into cash.
An option might be to let unemployment fall below 5% which make the labour supply more scarce bidding up wages and prices – with inflation reaching the target of 2%. Furthermore higher wages should entice workers back into the labour force. The risk is that with close to 0% interest rates inflation could rebound suddenly forcing the Fed to raise interest rates. How the Fed cope with the dual mandate next year will be interesting although the safe option could be to increase rates in the June this year. Below is a clip from Paul Solmon of PBS which explains the concern that the Fed have. It also stars Merle Hazard with a song about the dual mandate.