For many, the 1970s conjures up colourful memories, from John Travolta tearing up the dance floor in “Saturday Night Fever” to the break-up of the Beatles. For others, however, it brings to mind the threat of runaway inflation.
In his speech on Thursday, Narayana Kocherlakota, President of the Minneapolis Fed, reminded us of the power that the runaway inflation gremlin still wields over policymakers today and why it’s time to put this particular bugbear to rest:
It’s fun and educational to read about the 1970s on the Fed history gateway. I encourage you to do so. But it’s critical for monetary policymakers like myself to realise that the times, and challenges, that we face are different from the ones that Mr. Willson wrote about back in 1974.
He noted that, far from having to fight a running battle to hold back rising prices, the Fed has seen inflation average 1.5% over the past seven years. That is a full 50 basis points below the Fed’s target of 2% and there is little sign that it is likely to alter its trajectory in the near future.
There’s a reason why the Fed targets 2% inflation. That is the level that economists estimate is consistent with the largest number of people who want to work being able to find a job. As Kocherlakota points out, this period of low inflation suggests that nearly seven years after the onset of the financial crisis, the economy is still running some way below its potential, leaving some of its resources (e.g. the involuntary unemployed) going to waste.
The timing of his speech is particularly interesting coming on the heels of a Fed paper suggesting that one of the measures of slack in the U.S. labour market may have been sending out false signals. Despite the gradual improvement in the numbers of Americans able to find work since the crisis, the participation rate, (the share of the total working age population in or looking for work) remains 3% below its 2007 level.
For some, the fall in the participation rate is a sign that there is more slack in the labour market than the unemployment rate would suggest. This would mean that it would be appropriate for the Fed to leave interest rates lower for a longer period of time before needing to worry about inflationary pressures.
But the authors of the new Fed paper suggest that only about 0.25-1% of the fall in the participation rate can be reversed. The rest, they claim, is due to irreversible factors such as an ageing society and higher school enrollment among the young.
If they are right that would mean further improvements in the job market could start leading to price pressures sooner than many in the Federal Open Market Committee were expecting. It would be a mistake, however, to read this as a cause to raise rates immediately. As Janet Yellen said in March:
The long-term unemployed can see their skills erode, making these workers less attractive to employers. If these jobless workers were to become less employable, the natural rate of unemployment might rise or, to the extent that they leave the labour force, we could see a persistently lower rate of labour force participation.
Hiking rates for fear of possible inflation can create the very problem that you’re trying to address. This could have terrible consequences for out-of-work Americans. I’m with Kocherlakota on this one, it’s time we left the 1970s behind.