Tag Archives: inflation

Rising Prices that Hit Home

Learning about inflation in Econ 411 and other classes, we economics students are familiar with the slow creep up in prices over time. At the current target rate of 2%, however, it is hard to notice inflation on a day-to-day basis. One must look at a long time period to see the true impact. Prices, however, can be sticky as firms raise their prices in larger increments over longer periods of time. As a piece in today’s Business Insider points out, two notable American consumer oriented businesses are planning notable price hikes within the next quarter – Chipotle and Netflix. Business Insider laments the negative effect this could have on American consumers who have faced higher than natural unemployment and stagnant wages but I believe that the two companies are right in increasing their prices.

Let’s start with Chipotle. Founded in 1993, the company has grown to over 1,500 locations and revenues of over $3 billion annually. From my experience, Chipotle is an incredibly popular fast dining option for most people I know from college students to families. It is also one of the most affordable. A full feature burrito or burrito bowl without guacamole or other extras currently costs less than $7. I have always viewed Chipotle as a high quality, value option when selecting a lunch or dinner spot. The news, therefore, that they are raising prices, did not really surprise me as I always believed this would be a possibility. The food items that go into burritos are commodities and Chipotle does not have much control over the cost of its food inputs. According to the company’s first quarter earnings release:

Food costs were 34.5% of revenue, an increase of 150 basis points driven by higher commodity costs. Higher commodity costs were primarily driven by inflationary pressures in beef, avocados, and cheese prices.

According to BusinessWeek steak prices have increased by 25% already this year while cheese and pork could rise by as much as 10% as well. It is fair for any company to pass on price increases to consumers, especially one that has maintained a steady price level for years like Chipotle. As with any item, the concept of price elasticity tells us that a price increase will likely lead some consumers to not buy the good, but considering that Chipotle is only planning an approximate 5% price hike, the increase should not deter too many hungry customers from buying burritos.

Netflix’s price hike brings up a similar point. Since they introduced their online streaming service in 2008, Netflix’s streaming subscriber count has passed 33 million in the US alone. And since they split their DVD mail order business from the streaming business in 2011, the price of a streaming subscription has remained $7.99 a month. As the company has accumulated more and more digital content – from AMC hits Breaking Bad and Mad Men to original content blockbusters like House of Cards and Orange is the New Black – the price of acquiring premium content has gone up. In order to continue to accumulate a world class content catalog, it makes sense for Netflix to increase the monthly subscription price by a dollar or two.

While Business Insider brings up a great point about the negative impact this could have on the American consumer, the danger is overblown. These are very small increases in services that were priced very reasonably to begin with. It will be interesting to see what impact this has on the number of customers at these two companies, but I can say that I will remain a loyal customer at both.

(Revised 5) Low Inflation

After meetings this weekend the International Monetary Fund is worried that low inflation in more advanced economies was slowing recovery in many global markets. Where the U.S., Japan, and the U.K. all have inflation around the 2% mark, the average inflation in emerging markets is much higher, around 6%. The major issue however, rises from the Euro Zone’s current inflation rate of 0.5%, well below their target inflation rate of 2%.

WO-AS013_INFLAT_G_20140413183603

 

The low inflation rate leads to less levels of consumption as well, hinder the debt reduction in major markets. With lower levels of consumption and debt reduction in advanced economies, there can be major problems in emerging markets including market volatility, something we have already witnessed this year. A higher market volatility lead to questions about true growth and managers pulling their investments out of the emerging markets, something that will definitely hurt the economies long term.

The European Central Bank, or ECB, could take a page out of the U.S. Federal Reserve and work more aggressively to increase inflations rates. The ECB could start buying up more assets to increase the current inflation rate. This in turn would help stabilize Europe’s export market and allow for emerging markets to regain a competitive edge.

This is something we have seen the US Fed complete, after the Great Recession in the US Market of 2009. fredgraph

You can se from the graph the major dip in the US market right before January of 2009. To combat the souring markets, the Fed decide to start buying up all the short term t-bills to lower the interest savings rate and increasing consumption. Although this lowered the interest rate, it was quite enough and the Fed had to act more aggressively. In September of 2011 it switch tactics and began buying long term mortgages realizing the interest rates were all tied together. The short term t-bills remained low, and consumption began rising. This was a more aggressive tactic than what was initially tried but it ended up working.

The ECB should have realized this sooner to try and boost their inflation rate. Currently, according to the ECB websites, the bank is controlling the monetary base to try and influence the inflation rate. It is clear, however, that they are falling very short of their mark. They too can switch to a more aggressive tactic, over what they currently use. Taking on a quantitative easing strategy like the Fed, could help increase the consumer spending and will help strengthen the Euro exchange rate. And a higher exchange rate in the Euro, will help level the overall playing field in the global economy. It is hard to believe it has taken the ECB this long to recognize a more aggressive may help the global economy.

Revised: The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most unique policy tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance is merely a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so allows investors to understand when and how future interest rates will change, thereby reducing uncertainty and encouraging investment today.  This heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  At the onset of the lost decade in the 1990’s, the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, just a few years after the NASDAQ crashed, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy changes), the zero lower bound necessitates its use even today.  Because the Fed is unable to lower short-term interest rates to their necessary, negative value, it has no choice but to alter long-term rates in an effort to stimulate today’s economy.

While forward guidance seems to have been an effective (though painfully slow) policy tool in the last 6 years, recent debate has me worried about its legitimacy.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once a 6.5% unemployment rate is achieved, the Fed should raise interest rates per it’s promise.  However an intriguingly titled Wall Street Journal article caught my eye recently.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me worried that the Fed will not keep its promise to raise interest rates once 6.5% unemployment is achieved.

The article notes that some Fed doves are concerned about low levels of inflation.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated average inflation of 1.3% (uncertainty about the effects of Quantitative Easing has resulted in more conservative stimulus).  As shown in the graph below, this discrepancy in rates has caused a large discrepancy between predicted and actual price levels.  Many doves support the continuation of low interest rates (even after unemployment reaches 6.5%) so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

Screen shot 2014-03-24 at 12.00.01 PM

I have two concerns about continually low interest rates.  The first relates to the motivation for boosting inflation.  I certainly agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates.  However, once the Fed reaches its 6.5% unemployment target, its has achieved its goals.  Accordingly there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promise.

The issue of commitment brings me to my second and more important concern about continually low interest rates: failing to raise interest rates undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a useful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change once unemployment reaches 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) think like me, they will also lose trust in the Fed.  Should private investors lose trust in the Fed, forward guidance will be eliminated as a policy tool entirely, making economic stimulus at the zero lower bound extremely difficult.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the long-term strategy of central banks.  But today, this consensus simply does not exist, and there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, this type of debate will always exist.  And I think this debate should exist.  The Federal Reserve would be foolish to not reassess its long-term strategies given changes in the economic environment.  Like a successful business, an effective central bank should not commit to a single strategy, but rather should address each economic situation individually to respond optimally.

For this reason, I believe forward guidance, while powerful, is a foolish economic tool.  In order to preserve private investors’ trust, forward guidance locks the Fed into a single long-term strategy, inhibiting its ability to respond to unanticipated changes in economic conditions.  Unfortunately, given the zero lower bound, forward guidance has become necessary (as short term interest rates of 0% do not provide sufficient stimulus).  Therefore, in order to eliminate forward guidance as a policy tool, I believe addressing the zero lower bound should be a key priority of central banks.  So long as the zero lower bound exists and forward guidance remains necessary, the Fed cannot do its job as well as possible.

Inflation Rises and Eases Fed’s Worries

The new data on inflation suggests that there has been an increase in inflation rate from 1.1% to 1.5%, easing worries of the Fed for the low inflation rate. As I have repeatedly wrote in the past posts about US recovery and surfacing evidences that might suggest this, I would like to touch base again on stock market, housing price, employment, US financial climate and worldly financial climate.

First and foremost, I want to reiterate that this should be a great relief for the Fed. Taking away the food and energy bundle from CPI, the core inflation rate is actually higher at 1.7% only three basis points away from the inflation target of 2.0%. Just two months ago, chairwoman Yellen was worried that inflation rate was too low at 1.1%. However, the current situation will give the Fed more room to play with easy money supply and (real) interest rate. Continuing from previous worries over early interest rate increase among investor also can be mitigated a little bit. The unemployment rate still has not changed from 6.7%.

Screen Shot 2014-04-16 at 10.40.47 AM (source: here)

As chairwoman Yellen stated last month that interest rate increase will be on schedule with incumbent plan in place, this is a good news for most investors.

A WSJ article suggests that this increase in inflation is largely due to housing and food price rise. However, I have some doubts in this article. First of all, the food prices are very volatile anyways, so what we should be looking at is the core inflation rate. In regards to the housing market, yes, the homebuilders have beat the market expectation, but if the trend of expectation was very low in the first place, they do not have to much influence in the market. The article I found suggests the following:

U.S. housing starts rose 2.8% in March to a seasonally adjusted annual pace of 946,000, fueled by growth in single-family homes, the Commerce Department said Wednesday. Starts for February were revised higher, showing a slight gain that month instead of the initially reported decline.

But other figures indicated the recovery remains dicey despite the onset of spring. Compared with a year earlier, housing starts were down 5.9% in March. And building permits, a bellwether of future construction, declined 2.4% in March from the prior month to a pace of 990,000, marking the fourth drop in five months.

Therefore, I think it is still early to predict that the recent turnaround in the housing market can be a positive sign for long term stability.

In terms of stock market, the market has been faring very well in the past 5 years or so. Ant the Pesky Indicator says US stocks are still undervalued, leaving room for more appreciation in value in the future. For more macro US stock market analysis, please refer to my recent blog here. In short, the market has been faring well since the great recession, and even at 10 year level of macro investing, it would have given you close to 5% return–much higher level you expect from safe bonds and other savings.

At international level, I want to talk specifically about China. Although their GDP growth is at 6th quarter low at 7.4%, that is still a very big number. Also this number is still beating most analysts’ and economists’ expectation. We know from rule of 70 that in less than 10 years China would double the size of their economy. There also has been a recent regulation cut down from Chinese government that rural banks’ reserve requirement would be lower. This would work as easy money for Chinese and many investment projects can be financed more easily.

Overall, I would like to restated–as I have repeatedly done so in my past posts– US economy is on a recovery track. A very good one too. Thusly, I am pretty optimistic about the market for the next 2 and a half quarter to about a year or so.

Retail Sales and Producer Prices Go Up

Following three slow months, retail sales jumped 1.1% in March. According to the Wall Street Journal, “Retail sales increased 1.1% last month… the reading was the best monthly gain since September 2012”. Strong retail sales, which are an important piece of U.S. consumer spending, could be an indication of accelerating economic growth. The healthy pickup in consumer spending suggests that weaker spending in recent months was an outlier likely due to severe winter weather.

The automotive component of retail sales led the rise with an increase of 3.1%, which reflects a significant jump in new vehicle sales. According to the Wall Street Journal, “March auto sales, as measured in dollars, rose 3.1% from the prior month. That was the best gain in a year and a half”. Purchasing a new vehicle can be a big investment. Thus, many households make use of auto loans. As a result, the increase in auto sales might also reflect improvements in private credit markets. The availability of credit plays a central role in the booms and busts of business cycles.

In addition to auto sales, other components of retail sales were also solid. According to the Wall Street Journal, “Spending also improved at general merchandise stores, restaurants and nonstore retailers, which includes online shopping… Excluding automotive purchases, sales advanced 0.7% in March, above the forecast 0.4% gain”. Retail sales beat expectations even without including the large contribution by auto sales. I think it is good that the surge in retail sales were well distributed among several different areas rather than being highly concentrated in one (i.e. auto sales). The strong retail sales in March helped restore my confidence in the economic recovery following the weaker data in December and January. The severe winter weather seems to have caused December and January to be outliers among the stronger overall trend in consumer spending.

Retail sales are meaningful component of consumer spending, which is a significant piece of gross domestic product (GDP). According to the Wall Street Journal, “Consumer spending accounts for more than two-thirds of U.S. economic output. As such, expectations for stronger economic growth this year are largely pinned to shoppers’ wallets”. Due to strong retail sales in March, some economists have raised their projections for GDP growth in the second quarter. Consumer spending is a pro-cyclical component of GDP, which means it is positively correlated with GDP. If consumer spending picks up, then we should expect GDP to follow.

Another good sign for the U.S. economy is that producer prices increased 0.5% in March, which might predict a rise in U.S. inflation. According to the Wall Street Journal, “The producer-price index for final demand, which measures changes in the prices businesses receive for their goods and services, rose a seasonally adjusted 0.5% from February”. Although the producer-price index (PPI) is not the Federal Reserve’s preferred measure of inflation, the PPI is still a useful gauge of U.S. inflation. Considering the prolonged period of low inflation, I welcome the increase in the PPI and believe it might be a good sign for the U.S. economy. Furthermore, the 0.5% increase is a noticeable change as it is the largest gain in a single month since January 2010.

Not only does rising prices indicate inflation, it also reflects increasing demand. The increase in demand can also be seen in the strong March retail sales. I think the March employment report, which showed a hiring rebound after the winter slowdown, contributed to the rise in the PPI and the jump in retail sales. When you have a job you are able to spend more and increase your demand, which pushes up prices. The labor market is incredibly important and I completely agree with Janet Yellen’s emphasis on promoting job growth. A healthy labor market is an indispensable component of economic growth.

Low Inflation

After meetings this weekend the International Monetary Fund is worried that low inflation in more advanced economies was slowing recovery in many global markets. Where the U.S., Japan, and the U.K. all have inflation around the 2% mark, the average inflation in emerging markets is much higher, around 6%. The major issue however, rises from the Euro Zone’s current inflation rate of 0.5%, well below their target inflation rate of 2%.

WO-AS013_INFLAT_G_20140413183603

 

The low inflation rate leads to less levels of consumption as well, hinder the debt reduction in major markets. With lower levels of consumption and debt reduction in advanced economies, there can be major problems in emerging markets including market volatility, something we have already witnessed this year. A higher market volatility lead to questions about true growth and managers pulling their investments out of the emerging markets, something that will definitely hurt the economies long term.

The European Central Bank, or ECB, could take a page out of the U.S. Federal Reserve and work more aggressively to increase inflations rates. The ECB could start buying up more assets to increase the current inflation rate. This in turn would help stabilize Europe’s export market and allow for emerging markets to regain a competitive edge.

This is something we have seen the US Fed complete, after the Great Recession in the US Market of 2009. fredgraph

You can se from the graph the major dip in the US market right before January of 2009. To combat the souring markets, the Fed decide to start buying up all the short term t-bills to lower the interest savings rate and increasing consumption. Although this lowered the interest rate, it was quite enough and the Fed had to act more aggressively. In September of 2011 it switch tactics and began buying long term mortgages realizing the interest rates were all tied together. The short term t-bills remained low, and consumption began rising. This was a more aggressive tactic than what was initially tried but it ended up working.

The ECB should have realized this sooner to try and boost their inflation rate. Currently, according to the ECB websites, the bank is controlling the monetary base to try and influence the inflation rate. It is clear, however, that they are falling very short of their mark. They too can switch to a more aggressive tactic, over what they currently use. Taking on a quantitative easing strategy like the Fed, could help increase the consumer spending and will help strengthen the Euro exchange rate. And a higher exchange rate in the Euro, will help level the overall playing field in the global economy. It is hard to believe it has taken the ECB this long to recognize a more aggressive may help the global economy.

Increase in PPI Causing Inflation?

ppi-1yr

 

The producer-price index (PPI) for final demand, which measures changes in the prices businesses receive for their goods and services, rose a seasonally adjusted 0.5% from February, as we can see from the above FRED graph. According to Wall Street Journal, it rose 0.6% excluding the volatile categories of food and energy.

Since PPI indicates an overall rise in the prices business receive from buyers such as governments, consumers and other businesses for a wide array of goods services, we would expect an increase in inputs leading a rise in price for the final consumption goods. The U.S. has experienced a prolonged period of sluggish price increases, with inflation undershooting the Fed’s 2% target for 22 consecutive months. The CPI was up 1.1% in February from a year ago and rose 1.6% excluding the volatile categories of food and energy. The PCE index was up 0.9% in February from a year earlier and rose 1.1% excluding food and energy.

In my understandings, I believe that businesses would open their eyes to cheap inputs from foreign markets so as to guarantee their profit margin. The demand for imported inputs will increase resulting in rise of prices in imported goods, according to ECON 101 demand and supply model. The latest report from Labor Department said that prices for imported goods increased 0.6% in March from a month earlier, on top of February’s 0.9% increase. Import prices last month were still down 0.6% from a year ago.

China would be a big market for cheap imports again, as I once wrote in my early post. The policy of devaluating Chinese Yuan not only slows down China’s GDP growth but also makes Chinese goods cheaper to be imported for other countries. This policy has effectively increased foreign demand for Chinese goods and services and stimulated exports to a new higher level. Given that the domestic inputs prices increase. the US would shift to foreign markets, where China is a demanding one.

However, inflation would pose a lot of risks to economic performance therefore the policy makers are now trying to control it. Looking back to CPI, if businesses have already found ways to reduce their costs of inputs, the inflation may not be serious as we thought. The good news is that Overall prices for goods were flat in March. Food prices rose a seasonally adjusted 1.1% from February while energy prices sank 1.2%. Therefore we still cannot tell whether the increase in inputs of businesses will eventually lead to an increase in inflation.

 

Brazil’s Dilemma- High Inflation, Low Growth.

When Brazil was selected to be a host country for World Cup 2014, many foreign investors invested in Brazil, expecting a high return. Brazil, one of emerging economies of BRICS, had a rapid economic growth of 6.1% in 2007, when Brazil was elected as host country for World Cup 2014. As World Cup 2014 is quickly approaching, many economists are forecasting Brazil’s economy. But, it is not as optimistic as Brazil’s soccer team winning the World Cup 2014 trophy.

According to the article from Bloomberg Businessweek Brazil Economists See Faster Inflation and Slower Growth in 2014, Brazilian economists forecasted that Brazil’s inflation rate will continue to rise while its economic growth is getting slower and slower. The economists forecasted that Brazil’s inflation rate will rise to 6.35% from 6.30% while growth rate will decrease from 1.69% to 1.63%. The main reason for inflation is Brazil’s drought which drove the food price up.

The two graphs below is obtained from Federal Reserve Economic Data website. After reading the article above, I thought it would be interesting to see how Brazil’s Consumer Price Index and GDP changed over the course of years. From the Consumer Price Index graph, it can be seen that price level has been rising constantly, with a higher rate beginning from July 2013.  The economic growth rate graph from FRED shows a similar trend that was mentioned in the article above. In 2007, Brazil’s growth rate was 6%, when it was selected to host World Cup 2014. From then, the economic growth rate decreased drastically, as low as -0.3% in 2009. In 2010, Brazil’s economic growth recorded a 7.5% high, due to larger spending from the middle class. However, from then Brazil’s economy has been suffering  since then, as growth rate has been in the 1~2% range.

brazil cpi BRAZIL Growth rate

 

Brazil’s central bank has been trying its best to control its high inflation rate. According to the Wall Street Journal article Brazil Central Bank Hints at End to Rate Increases, Brazil’s central bank raised its interest rate for ninth consecutive times, from 10.75% to 11%. This increase in interest rate is to deal with the inflation from supply shock of food crops due to draught.

However, I am worried that Brazilian Central Bank’s decision to increase its interest rate even more will deteriorate Brazil’s economic growth rate. Brazil’s interest rate of 11% sounds really high, and it cannot be a permanent solution for Brazil’s inflation as Brazil’s inflation is mainly based on the supply-shock of food crops. Brazil’s atmosphere is getting hotter and hotter for world’s expectation of its World Cup, yet Brazil’s economy will need more time to recover.

(Revised) Fed, Raise the Inflation Target

Originally posted on March 29th

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”? In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?

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.