Does targeting low inflation cause higher unemployment?

Does targeting low inflation lead to higher unemployment?

In other words, is it possible that a higher natural rate of unemployment is necessary to maintain a lower rate of inflation?

Output and prices move together to maintain economic momentum. Normally output increases in response to demands in the market, which keeps prices stable. Yet, at those times when output cannot respond to the momentum of the market, prices will rise giving space for output to catch up. A higher natural inflation corresponds to when consumers have strong liquidity. A lower natural inflation corresponds to when consumers have less liquidity and are less able to drive the momentum of the market. When consumers have low liquidity, output finds it easier to respond to demands in the market, so price increases are less needed.

The basic idea is that if prices are constrained from rising when there are inflation pressures from commodities or consumer demand, jobs will be cut short. Firms will not be able to maintain as much labor. The increased pressures from costs not being released through higher prices will cut into production possibilities. Thus, higher unemployment corresponds with a lower inflation target.

Joseph Stiglitz wrote back in 2008…

“Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much impact on inflation; it will only make the task of surviving in these conditions more difficult.” (source)

Does inflation have a natural rate? This seems to be the key question. Unemployment has a natural rate. Even GDP has a natural rate. If you push unemployment below its natural rate, you get problems of economic over-heating. If you push GDP above its natural rate, there are risks of inflation and economic over-heating too. What would it mean if the natural rate of inflation for the US was 3%, and the Fed kept trying to push it to 2%?
Here is an analogy. The natural rate of inflation is like a shock absorber on a car. You have bumpy roads where you live. So you have shock absorbers on your car that have a greater range of movement for the bumpy roads. When you keep your car speed commensurate with the conditions of the road, you have a comfortable ride.
Then the roads all start getting paved and made smoother. Over time the shock absorbers stiffen, which creates a more stable ride on smoother roads. You can actually drive faster now too. But if you then try to drive your car on the old bumpy roads, you will have to drive much slower or get tossed around.
A 2% inflation target is like paving the roads and streamlining transportation so that it can move faster with a more stable and smoother ride. But if the road ever gets bumpy, the tight range of the shock absorbers make you slow down much more on bumpy roads. A tighter inflation range restricts leeway in economic adjustments. The result from an economy going slower during rough times would imply higher unemployment. A higher inflation range would allow the economy to move faster on bumpy roads. An economy moving faster means lower unemployment.
The relationship between inflation and unemployment is also found in the Phillips curve, where you have inflation on the y-axis and unemployment on the x-axis. The curve can be vertical or downward-sloping. If the curve is downward-sloping, like the right side of a capital A, then higher inflation would bring the unemployment rate down. But it is a tricky game with monetary policy. If the Federal Reserve sets an inflation target of 2%, and people really expect 2% inflation (Fed policy has credibility) and the inflation rate averages 2%, then people get used to the rhythm of the economy and the inflation target matches the speed.
However, if the Federal Reserve was to set a higher inflation target and not tell anyone, people would feel comfortable even as the economy is moving faster. If the car is riding smooth, could the Fed slowly speed up the car without anyone really noticing and getting nervous? Could the Federal Reserve take advantage of stable inflation expectations?
“Should the central bank try to exploit the downward-sloping long-run Phillips curve and secretly, by being more expansionary, try to keep average inflation somewhat above the target, so as to induce lower average unemployment than for average inflation on target? Such a policy would involve the central bank saying one thing (the target is 2 percent) and deliberately doing another (keeping average inflation above 2 percent). This would be inconsistent with an open and transparent monetary policy. Regardless of the moral quality of the policy, the truth might eventually be leaked or discovered, in which case the inflation target would lose credibility and inflation expectations would rise above the target, in which case the possible benefit of inflation above target would vanish.” (source)
If the Fed tried to temporarily set a higher inflation target when the economy was moving smoothly, as soon as the economy hit some rough roads, the Fed would have to tighten more than if they hadn’t secretly been so loose and free. Some say this is what happened before the crisis.
So back to the original question…
Is it possible that a higher natural rate of unemployment is necessary to maintain a lower natural rate of inflation? Yes it is possible. A higher rate of unemployment puts less pressure on inflation, thus making it easier to keep inflation low.
Another way to look at this is… The Fed has been in a long-term plan to beat inflation down to 2%. By pushing the inflation rate lower for so many years, the economy has now shifted its institutions and dynamics into an equilibrium state of low inflation, which required a rise in the natural rate of unemployment to minimize inflation pressures.
The flip-side of this issue, is that… If the Fed was to now target lower unemployment, they would have to accept higher inflation pressures. Yet, the economy is structured around very low inflation. and We all know the Fed has decided in favor of keeping inflation under control. The trade-off is higher unemployment, subdued wage growth and low demand pressures.
So, to wrap up… the Fed has its 2% inflation stability, which is now projected to last for years. But the economy is needing more adjustment room from prices (inflation) in order to generate more economic momentum for output. More economic momentum for output would translate into more employment. The economy is needing a higher inflation target, but the Fed does not want to raise the inflation target, and even if they wanted a higher inflation target, they couldn’t achieve it, either secretly or openly. The economy is now stabilized at an equilibrium with lower inflation and higher unemployment.