The US Federal Reserve’s decision to delay an increase in interest rates should have come as no surprise to anyone who has been paying attention to Fed Chair Janet Yellen’s comments. The Fed’s decision merely confirmed that it is not indifferent to international financial stress, and that its risk-management approach remains strongly biased in favor of “lower for longer.” So why did the markets and media behave as if the Fed’s action (or, more precisely, inaction) was unexpected? What really shocked the markets was not the Fed’s decision to maintain zero interest rates for a few more months, but the statement that accompanied it. The Fed revealed that it was entirely unconcerned about the risks of higher inflation and was eager to push unemployment below what most economists regard as its “natural” rate of around 5 percent.
It is this relationship — between inflation and unemployment — that lies at the heart of all controversies about monetary policy and central banking. And almost all modern economic models, including those used by the Fed, are based on the monetarist theory of interest rates pioneered by Milton Friedman in his 1967 presidential address to the American Economic Association.
Friedman’s theory asserted that inflation would automatically accelerate without limit once unemployment fell below a minimum safe level, which he described as the “natural” unemployment rate. A few years later, Friedman’s “natural” rate was replaced with the less value-laden and more erudite-sounding “non-accelerating inflation rate of unemployment” (NAIRU). But the basic idea was always the same. If monetary policy is used to try to push unemployment below some pre-determined level, inflation will accelerate without limit and destroy jobs. A monetary policy aiming for sub-NAIRU unemployment must therefore be avoided at all costs.
The inflation-targeting models used by the Fed assume the existence of some pre-determined limit to non-inflationary unemployment. The Fed’s latest model estimates this NAIRU to be 4.9-5.2 percent. And that is why so many economists and market participants were shocked by Yellen’s apparent complacency. With US unemployment now at 5.1 percent, standard monetary theory dictates that interest rates must be raised urgently. Otherwise, either a disastrous inflationary blowout will inevitably follow, or the body of economic theory that has dominated a generation of policy and academic thinking since Friedman’s paper on “rational” expectations and “natural” unemployment will turn out to be completely wrong. What, then, should we conclude from the Fed’s decision not to raise interest rates? One possible conclusion is banal. Because the NAIRU is a purely theoretical construct, the Fed’s economists can simply change their estimates of this magic number. In fact, the Fed has already cut its NAIRU estimate three times in the past two years.
This does not imply permanent near-zero US interest rates. The Fed will almost certainly start raising rates in December, but monetary tightening will be much slower than in previous economic cycles, and it will be motivated by concerns about financial stability, not inflation. As a result, fears about the impact of Fed tightening on global economic conditions will probably prove unjustified.
The bad news is that the vast majority of market analysts, still clinging to the old monetarist framework, will accuse the Fed of “falling behind the curve” by letting US unemployment decline too far and failing to anticipate the threat of rising inflation. The Fed should simply ignore such atavistic protests, as it rightly did last week.
© Project Syndicate
