Its one of the most fundamental truths of economics and life in general: We all face tradeoffs. When we try something different a new product or a new job, for example we have to give up on alternative uses of our money and time. The costs of such choices can be substantial. But when it comes to monetary policy, the Fed acts as if its choices are costless.
In January 2012, the Federal Open Market Committee adopted what it calls the Statement on Longer-run Goals and Monetary Policy Strategy. This policy document states that a 2 percent long-run inflation goal is consistent with a long-run normal rate of unemployment between 5.2 and 6 percent. More recently the Fed has said the extraordinary purchases of long-term bonds will continue as long as the unemployment rate remains above 6.5 percent.
The Fed is saying the benefits of bank interest rates near zero and low long-term government bonds rates exceed the costs of 2 percent inflation. The Fed hopes that in response to low rates businesses will invest and hire more, and consumers will buy more big-ticket items like homes and cars, lowering unemployment.
Before considering the direct costs of these policies, the Fed should ask if the supposed tradeoff between inflation and unemployment even exists.
In 1958, English economist A.W. Phillips published a report detailing a negative correlation between inflation rates and unemployment. This was soon confirmed by U.S. economists using data from the early part of the 1960s.
But a decade after Phillips finding, Nobel Prize-winning economists Milton Friedman and Edmund Phelps showed that such policy tradeoffs were only good for a short time, if at all. In the long run, low interest rates have no real effect on the economy.
In the long run it may be normal to see unemployment between 5 and 6 percent but the Fed cannot influence this rate by simply creating money. The number of workers who cant find work depends on many factors, including labor productivity and the rate at which new businesses arise.
Since the U.S. economy fell into recession in 2008, the Fed has been playing the supposed inflation-unemployment tradeoff. For five years now, inflation and unemployment have averaged 2.1 and 8.3 percent, respectively.
For Western U.S. cities such as Boise and in Idahos labor market, the tradeoff appears to be slightly better. Inflation here over the past five years has averaged 1.7 percent and unemployment 7.2 percent.
Five years of inflation, however, have not produced normal unemployment. Either the Fed believes the long run is much greater than five years, or the relationship no longer exists.
And what are the costs of trying to manipulate this supposed tradeoff? Economic theory predicts a number of costs from rising prices, including the increased variability of relative prices, unintended changes in tax liabilities, and arbitrary redistributions of wealth.
With positive inflation, the Feds policies of low interest rates benefit the young over the old. For example, a college student taking out a $10,000 loan today at 7 percent interest will owe about double that in 10 years when the loan comes due.
Meanwhile, those households with savings in the bank earning 1 percent or less primarily the elderly are earning a negative real rate of return after inflation. The Feds low interest rates are like a tax on the elderly to help the young.
We all face tradeoffs. But the Fed is fighting the wrong battle and hurting many in the process.