Overshooting Unemployment Rate

In recent discussions regarding the Fed’s timing of raising the interest rate and stopping the QE, the possibility of overshooting the unemployment rate to make sure the the economy doesn’t slip back to the panic after the Fed’s move. What overshooting the unemployment rate means is that the Fed waits the unemployment to get below “natural rate”, let’s say 5.5 percent, to raise the interest rate. Advocates of overshooting say that by doing so, the economy can gain lost capacity during the recession, and slightly higher inflation and nominal interest rate can benefit the economy in terms of more monetary policy room to kick another panic.

This argument of overshooting unemployment rate is one of the fundamental macroeconomics topics Milton Friedman addressed in his 1967 American Economic Association speech, titled “The Role of Monetary Policy”. According to him, lower than “natural” rate of  unemployment can be achieved through only increasing inflation. The key word here is increasing, since at the moment when he gave the speech, there was spreading view that there is trade-off between higher inflation and lower unemployment. Friedman argues that when the central bank raises the quantity of money supplied by buying bonds, it increases the money supplied higher than the amount people want to hold; therefore, it reduces the nominal interest rate and increase demand for goods. Companies would respond to increase in demand by first supplying more of the goods without increasing the prices. But eventually price would adjust to the demand by rising. At the same time, wages doesn’t rise as much as the price rises. Therefore, real wage would be decreased during this phase. 

Decreasing real wage would lead to higher employment. This is why we could see higher employment or lower unemployment through unexpected inflation rise. However, once the workers starts including the higher inflation rate to decide what wage to receive, they demand higher wages. Since the unemployment was lower than natural rate and the higher wage demand, the real wage starts increasing. The increase in real wage would then increase unemployment back to the normal level. If then the policymakers still want to pursue lower than natural unemployment rate, they now have to increase the supply of money  at higher than previous rate. Hence, we could see increasing price level or inflation as this process goes on forever until the policymakers decides to not target unemployment rate lower than natural rate.

How this discussion relates to current policy making is that if the Fed decides to pursue the unemployment rate below natural rate, 5.5 percent in our case, permanently, the Fed will face a problem of increasing inflation. i believe, the Fed will pursue it for one or two years if it indeed decides to it. Even though one or two years isn’t permanent, it is neither temporary. Therefore, the Fed will face some inflationary pressure. Some might say there won’t be high inflation since we are having low inflation now, but at the moment we pass the natural rate of unemployment, say 5.5 percent, the inflation will be back to the level of normal times.

When making decision of pursuing a low level of interest rate even after the unemployment rate reaches natural rate, the Fed policy makers should calculate the risk of increasing inflation.