Should the Fed look at bubbles not inflation?
John Cassidy wrote a piece in The New Yorker which focused on the US Fed targeting the threat of bubbles rather than inflation when implementing policy instruments. In the mid 1990’s and early 2000’s the Fed set interest rates based on the supposed threat of inflation. However price rises never materialised so the low interest rates fueled borrowing especially for purchasing property.
In the past, expansionary monetary policy (low interest rates) would have acted as a catalyst to the real danger of a wage price spiral in which rising wages and prices become self-reinforcing, pushing inflation up. This was very apparent in the winter of 1974 in the US when inflation reached 12% and 15% by 1980. But today with the annual rate of inflation in the US at less than 2% for the past three years the threat of another wage price spiral is fairly dormant. It was forecast that that wage and price inflation would start to rise but average hourly earning rose by just 0.1% in January. Over the course of the past year, it has risen by 2%, which is a very modest rate of increase.
Economists have never been able to pin down the jobless rate at which inflation takes off—the so-called NAIRU, or Non-Accelerating Inflation Rate of Unemployment. Theoretically, the concept makes sense. Empirically, it’s extremely elusive, because it depends on many other things, such as the rate of productivity growth, tax rates, the labor-force participation rate, and the level of unionisation.
However higher wages will eventually surface with a tight labour market but the real dilemma for the Fed is the tradeoff between cheap money and financial instability. Keep interest rates too low for too long and you ignite another asset bubble or raise interest rates to alleviate the bubble risk but dampen growth in the economy?