There will, predictably, be calls to respond to the good news by normalizing monetary policy, raising interest rates soon. And we will want to raise rates off zero at some point. But it’s important to say that (a) we are still highly uncertain about the underlying strength of the economy (b) the risks remain very asymmetric, with much more danger from tightening too soon than from tightening too late.
now is the time for the Federal Reserve to establish its credibility on the point that, if the economy enters a liquidity trap, the Fed is going to keep stimulating until the economy is out of the liquidity trap and interest rates can normalize. If the Fed does not do this now, future Fed Chairs will curse its name.
If unemployment does fall to 5% next year, that should have two beneficial effects for the labour market. First, it should push up wages. Hourly earnings rose 0.4% in November, an unexpectedly brisk and long overdue increase. But they are still up just 2.1% from a year earlier. Since profit margins are so wide, it will take several years of stronger wage growth to generate cost-push inflation. Second, some of the long-term unemployed who have quit the labour force should be drawn back in, reversing some of the loss of potential output brought about by the prolonged period the economy spent depressed.
To get inflation higher requires a negative output gap by allowing unemployment to fall below its natural rate for a time.
I’d just like to note that Krugman and DeLong complement each other as usual (and to compliment both as usualer). Brad notes a long term reputational advantage of inflation over 2% — I follow Brad who followed Woodward who followed Krugman in believing that, when the economy is in a liquidity trap, it is good for the monetary authority to credibly promise that it will allow inflation to rise above the normal target after the unemployment rate falls to the non accelerating inflation rate of unemployment (google “credibly promise to be irresponsible”). As Brad notes, a FOMC doing exactly that can only make it easier for future FOMCs to convince economic agents that it too will do exactly that.
Is this possible benefit which may or may not arrive in the distant future worth the costs of inflation slightly above 2% ? Of course it is. There is no jump in the marginal cost of a bit more inflation at 2%. 2% isn’t an especially important number**. If the 2% target was chosen rationally to maximize some reasonable social objective***, then a small benefit of higher inflation makes the optimal inflation rate higher.
The justification for choosing and inflation target, declaring it, and sticking to it is that it is possible for a clear simple rule which is followed mechanically to become credible. The risk that people will thing “the official target is 2% but next time we are in circumstances like these inflation will be allowed to get higher than 2%” is the reason to accept NAIRU unemployment when the unemployed wish they had jobs. In this case, it is a benefit.
It is possible to make an argument which isn’t internally logically inconsistent for raising the target Federal Funds rate — it is possible to make a logically consistent argument for anything if one is allowed to make any assumptions one pleases. But the argument actually made for higher rates soon is about as close as one can get to logical inconsistency if one is allowed to invoke confidence fairies, expected inflation imps and the whole pseudopsychological menagerie.
* Why did I link to Mark Thoma not to DeLong and whoever G.I. might be directly ? Well my original interest was in Mark Thoma and links not in policy and public welfare. I got to http://economistsview.typepad.com by clicking a link at www.sitemeter.com.
** I am referring to a vague memory (sorry no link) of Paul Krugman discussing US net capital income (GNP minus GDP) with Larry Summers in 1988 and saying “people who are smart enough to understand all that are smart enough to understand that zero isn’t an especially important number.” I thought that wasvery smart. I find it ironic that a few years later, he saw that the liquidity trap was baaack (pdf warning) and that, when it comes to nominal interest rates, zero is a particularly important number.
*** Note the if. I no more believe that the 2% target was chosen because it maximizes some social welfare function than I believe in unicorns.