Inflation or Why Raise Interest Rates

May 26, 2016

3 minute read

Inflation or Why Raise Interest Rates

by David Blitzer, Chairman of the Index Committee, S&P Dow Jones Indices

The minutes of the Fed’s April 26-7 meeting convinced almost everyone that the Fed will raise interest rates at its next meeting in June, but left them wondering why. Most of the subsequent discussion centered on the labor market and how close the economy is to full employment. There was also some whispering about inflation.

The Fed has two sometimes conflicting goals: full employment and low inflation. It defines low inflation as 2%. The definition of full employment is less specific — an unemployment rate in the neighborhood of 4.5%-5% seems right. Since 2009 the Fed has moved towards full employment by bringing the unemployment rate down from 10% to 5% currently. It has had less success with inflation unless you really want price increases of zero to 1% instead of the Fed’s 2% target.

Inflation used to be thought of as a monetary phenomenon – the growth rate of the money supply drove the rate of inflation. Despite consistent money growth, inflation remains comatose. The competing inflation theory is a combination of expectations and the Phillips curve. Expectations is the idea that when everyone expects prices to rise, they will push for higher wages and prices; but be satisfied with current wages and prices if they expect stability to continue. The Phillips curve was first suggested in 1958 by A. W. Phillips, a New Zealand economist, who described an inverse relation between inflation and unemployment: when unemployment drops and an economy reaches full employment, inflation tends to rise. While the details of the links among inflation, unemployment and expectations have changed, the links are still there and the Fed believes that full employment can lead to rising inflation. The FOMC doesn’t know how far or fast unemployment can fall before inflation picks up. However, waiting to raise interest rates until inflation is climbing would mean needing to push interest rates up much farther and faster. A small step or two in interest rates this year may be prudent risk control.

Concern over inflation and the Phillips curve is not the only argument for a June-July rate hike. Over the last year the Fed has discussed normalization – moving interest rates above the zero lower bound and returning to open market operations and the Fed funds rate as the principal tools of monetary policy. If the Fed funds rate is still 0.5% at the start of the next recession, there won’t be much room to ease and the Fed would immediately be looking at quantitative easing, negative interest rates and an expanding balance sheet. A better plan would be further economic growth and gradually moving the Fed funds rate to 2%-3% before faced with the next downturn. That plan needs to start sometime.

One other aspect of a Fed move is more speculative. While the Fed’s policy mandate for low inflation and full employment is domestic, the Fed’s action is felt around the globe. An increase the Fed funds target may boost the dollar against other currencies include the euro and the yen. A stronger dollar would stimulate some foreign economies while dampening activities for US manufacturing and exporting. This should be viewed as a side effect rather than disguised stimulus to other economies.