It’s nice to hear birds chirping in the morning. But the financial markets are hearing angry birds fighting over monetary policy.
In this game, the so-called doves — monetary policymakers who believe interest rates must be kept low — are trying to encourage consumer spending and higher employment. On the other side are the hawks, who want monetary policy tightened, meaning higher interest rates. Doves worry about slow economic growth. Hawks worry about higher prices.
Federal Reserve Vice Chairman Janet Yellen, for one, is clearly a dove. Dr Yellen said in a speech at New York University that continued high unemployment “underscores the case for maintaining a highly accommodative stance of monetary policy.”
Policy hawks, like Minneapolis Federal Reserve Bank President Narayana Kocherlakota, want to combat inflation. Dr Kocherlakota said that same week that the Fed should start reversing its ultra-loose monetary stance and raise rates in the next six to nine months.
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These policymakers are battling the long-time monetary policy tradeoff known as the Phillips curve. In 1958, English economist A. W. Phillips published a report detailing the negative correlation between inflation rates and unemployment. This empirical relationship was soon confirmed by U.S. economists.
The policy implication of these findings was important. When the Fed expands the money supply, as it has been doing now for years, it moves the economy along the Phillips curve to a point of lower unemployment, but at the cost of higher inflation.
Policymakers have a clear choice. How much inflation are they willing to tolerate in order to get people back to work?
A decade after Phillips’ finding, economists Milton Friedman and Edmund Phelps showed that such policy tradeoffs were good for only a short period of time. In the long run, low interest rates and the consequential growth in the money supply have no real effect on the economy. The Fed can’t do anything for the economy’s long-run unemployment rate.
In fact, when policymakers try to take advantage of any short-run trade-off between unemployment and inflation, they may create negative consequences.
Phelps showed that with this policy game going on, people will come to expect higher inflation over time. That is, they raise their inflation expectations. This makes the tradeoff in the Phillips curve worse: Higher levels of inflation are set against higher levels of unemployment. Graphically, the curve shifts up.
Doves like Vice Chairman Yellen have said the 2 percent inflation is OK, but expectations are rising. On April 12, the U.S. Department of Labor’s Bureau of Labor Statistics reported that on a seasonally adjusted basis, the Consumer Price Index rose at annualized rate of 2.7 percent through March, well above the Fed’s mark.
Much of the CPI increase is due to higher gasoline prices. Idaho has been fortunate when it comes to this inflationary factor. According to Oregon/Idaho AAA, gasoline averages $3.78 per gallon here, compared with $3.92 across the nation.
The situation is, however, getting worse as we head into the peak-driving summer months. According to a March Gallup poll, Americans expect $4.36 per gallon before year’s end. By this measure, the national policy tolerance for inflation has increased inflation expectations.
In order to win, the hawks will need to the move the fight from today’s inflation to expected inflation. We will see if the other birds are listening.
Peter Crabb is professor of finance and economics at Northwest Nazarene University in Nampa.