One of the most difficult — and important — tasks facing the Federal Reserve in the months ahead is developing a strategy to grow the economy without lighting the flames of inflation.
Unfortunately, years of economic stimulus and a short-term interest rate at or near zero have yet to achieve the desired goal of significant job creation, even though inflation is running at dangerously low levels.
Congress amended the Federal Reserve Act in 1977, stating the monetary policy goals of the Fed as, “maximum employment, stable prices and moderate long-term interest rates.”
While the nation’s unemployment rate has declined recently, analysts suggest it is for the wrong reason. A growing number of people have left the labor market because of tight job conditions, artificially driving down the unemployment rate.
The Fed, under the new direction of Janet Yellen, acknowledged the unemployment rate remains “elevated” and an increase in interest rates now would be ill-timed.
“Thus far in the recovery and to this day, there is little question that the economy has remained far from maximum employment,” Yellen said in a speech in mid-April at the Economic Club of New York.
“But as the attainment of our maximum employment goal draws near, it will be necessary for the Open Market Committee to form a more nuanced judgment about when the recovery of the labor market will be materially complete.”
She also acknowledged a change in Fed policy about what level of unemployment would trigger a move by the Fed to begin raising short-term interest rates.
“At 6.7 percent, it is now slightly more than one percentage point above the 5.2 to 5.6 percent central tendency of the Committee’s projects for the longer-run normal unemployment rate,” Yellen said. “This shortfall remains significant, and in our baseline outlook, it will be more than two years to close.”
This policy has started to raise concerns that the Fed may find itself in a position to fight deflation rather than inflation.
Dr. Lynn Reaser, chief economist at Point Loma Nazarene University’s Fermanian Business and Economic Institute, said, “Ms. Yellen believes that it would be much easier to fight higher inflation than lower inflation. Higher inflation can be addressed by higher interest rates, while lower inflation in an era of zero interest rates could be much more difficult to combat.”
The Fed is walking a fine line between inflation and deflation. And they appear to be doing it without a safety net. And, deflation can have a cascading effect on the economy.
“Weak consumption and declining prices often tend businesses and individuals to reduce investment, further slowing economic growth,” said Kathy Jones, vice president at the Schwab Center for Investment Research.
“It can also make it more difficult for governments, businesses and individuals to pay down debt. Finally, as Japan has learned over the past decade, once deflation takes hold, reversing it is easier said than done.”
As was the case under Ben Bernanke, members of the Fed see a direct link between wages and inflation. Until recently, wages have been growing at a rate closely linked to inflation. In other words, wage increases have been very slow.
A new report, however, from the Department of Labor says the median weekly earnings of the nation’s 104.3 million full-time workers rose to $796 in the first quarter of 2014, an increase of 3.0 percent compared to the same period a year ago.
The increase in wages is well above the 1.4 percent increase in the consumer price index in the first three months of the year.
There are many moving parts to the U.S. and global economies and coming up with the perfect strategy is no easy task for policymakers who try to deal with the inexact science of economics.
“If the economy obediently followed our forecasts, the job on central bankers would be a lot easier and their speeches would be a lot shorter. Alas, the economy is not so compliant,” said Yellen in her New York speech.