In Janet Yellen’s speech to the Economic Club of New York on Wednesday, she assured investors that low interest rates would continue and also focused on low inflation and economic slack. This was a follow-up to her meeting in March that left investors with the impression that interest rates would rise in the near future.
During the speech, Ms. Yellen made sure to point out that the economy is an uncertain place, and the Fed cannot lose sight of this as they propose monetary policy. However, she did give a more concrete prediction of when she expects to rise rates. She intends to keep interest rates low until at least the middle of 2015, given that the economic outlook allows the US to maintain low interest rates.
Another main point that Yellen stressed was the inflation rate target. She said that she was more worried about inflation becoming too low rather than too high. Later she added that the Fed’s focus should be on lifting inflation to the 2% target, not holding it down. During the speech, she commented, “The Fed is “well aware” that inflation could shoot above its 2% goal, she said. ‘At present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2%.’” Low inflation is a problem because it signals weak economic demand. Also, not leaving a large enough inflation threshold can lead to deflationary problems in the future. Deflation is detrimental to the economy because it leads to many painful outcomes- the combination of falling prices, consumers’ reduced likelihood of spending, and falling wages depresses the economy and sets it into a deflationary trap. This triggers a vicious circle because rising debt leads to less spending, which leads to further deflation… and repeat.
The problem comes into play when the Fed tries to dictate certain economic issues like long-term unemployment and income inequality. The Fed mentioned that it would like to see wage inflation because this would indicate that slack in the labor market is starting to disappear. Hence, they don’t want discouraged workers to get dropped out of the labor force permanently. Decreasing slack in the labor market will later get job creation back on track. However, the problem is that it’s hard for the central bank to influence these policies. At the end of the day, the central bank is chartered by congress as an independent agency within the government- not to be a policymaker itself. I think that in terms of the trade off between inflation and unemployment, the Fed has more control on the economy through dictating stable inflationary levels. As we have already seen, the Fed has abandoned the unemployment target because there are too broad of measures included that make up this target- many of which the Fed can only indirectly control, if at all. Although the two issues are interrelated- short-term unemployment is relevant for inflation, I believe that the Fed would get the most out of rising inflation back to the 2% target.