With the holidays upon us, the business community is anticipating sales and employment figures like kids awaiting Santa. In addition, a change in leadership at the Federal Reserve brings a new Chairman poised for installation on January 31st 2006. Fed chair nominee Bernanke proposes to bring more transparency to the Fed’s monetary policy, particularly in addressing the issues of inflation and unemployment. It’s a good time to consider, then, what economists mean when they talk about the economy “heating up” or “cooling off,” and why these issues are the special concern of Federal Reserve officials.
All monetary policy involves manipulation of the nation’s money supply. This is accomplished by the Fed through sales and purchases of Treasury instruments, changes in interest rates, or changes in reserve requirements. Yet fear that Federal Reserve policy will either “heat up” or “cool down” the economy too much is an ongoing concern of the business community, as well as of the Fed itself. This hot and cool notion has become so ingrained that good news from the Labor Department is often accompanied by speculation about possible “overheating”—bad news about inflation—in the economy.
The view that there is a tug-of-war between inflation and unemployment is one of the ideas advanced by J.M. Keynes in the 1930’s. Inflation and unemployment were mutually exclusive problems in Keynes’ model. Too little spending created unemployment (economy too ‘cool’). Too much spending, especially due to monetary expansion by the Fed, created inflation. One clearly couldn’t have both too little and too much spending, but the economy might lurch between inflation and unemployment if total spending and monetary factors were not perfectly in sync. The best the Fed could do was avoid creating inflation—in Keynes’ theory of macro policy, the Fed could not increase output or employment.
A.W. Phillips introduced a later and more popular version of the inflation-unemployment relationship in 1958. Phillips’ empirical observations revealed a tradeoff between wage inflation and unemployment, and became known as the Phillips Curve. With a unique rate of inflation associated with each rate of unemployment in the economy, policymakers could presumably choose the combination they desired. This also meant accepting a higher inflation rate in exchange for a lower unemployment rate, or vice versa. The economy ‘heated up’ (with the spectre of rising inflation) when unemployment fell, so good news for employment was often greeted as bad news for inflation. Fortunately, this tradeoff is not inevitable.
Low unemployment rates themselves do not cause inflation. Higher employment that is due to expanded productivity, or more complementary capital, creates no inflation. But employment that is created only because the Fed is increasing the nation’s money supply may be accompanied by higher overall prices—evidence of the monetary inflation.
Historical events have also debunked the idea of a strict inflation-unemployment tradeoff. High inflation and high unemployment were twin benchmarks of the 1970’s American economy, and didn’t fit the Phillips Curve predictions. Whether the Phillips tradeoff ever existed, or was merely unstable, has been the subject of much discussion.
Should we believe media reports that suggest falling unemployment will cost us greater inflation? Not necessarily. Incoming Fed Chair Ben Bernanke has declared that he wants a Federal Reserve policy that will address both inflation and unemployment, and a monetary authority that is more transparent in terms of monetary policy. Though the new regime at the Fed is likely to resemble the outgoing Fed regime, greater transparency could mean that worries of alternating economic ‘heating’ and ‘cooling’ are dampened by greater market certainty about the Fed’s monetary policy choices.
To the extent that markets are driven by expectations, the Fed’s biggest task will be to convince markets and the public that it can stick to its announced goals, such as the two percent inflation goal Bernanke named. If successful, the Fed’s effectiveness may indeed improve, and the misplaced characterization of an inevitable tug-of-war between inflation and unemployment begin to disappear.