(Bloomberg Opinion) -- Economists are increasingly united in their belief that unemployment in the U.S. can't go much lower without causing inflation. They are less united, however, in their belief that the Federal Reserve should be aggressively raising interest rates to prevent wages and prices from rising too fast. Paul Krugman writes in the New York Times:
I think the U.S. really is more or less at full employment. But do I think the Fed is right to be raising rates, and that we should start being worried about fiscal deficits? Actually, no, for two reasons. First, I might be wrong. And the costs of tightening when the economy still has room to grow are much bigger than those of waiting and discovering that we’ve overshot a bit.
I'd go further. I think that there is still substantial evidence that there are more employable Americans who want jobs. One suggestive indicator is the much higher rate of employment in other advanced nations among people in their prime working years. There just seems to be no reason that the fundamental U.S. employment situation has diverged so much from that of its peers.
U.S. unemployment has fallen to 3.8 percent and the number of job openings is now equal to that of job seekers. Yet there's still more room to recover from a recession so deep that at one point there were more than six job seekers for every U.S. job opening.
I could be wrong, of course. The data is ambiguous and the recession was deeper than any since the Great Depression. The aging population presents demographic changes that have never been seen before. Maybe the economy has changed in ways that no one fully understands.
What matters most isn't what economists like me think about the full employment debate but how the Fed is going to respond to it. The conventional wisdom is that it will aggressively hike rates if it thinks that the economy is already at full employment. The Fed, so the traditional theory goes, would want to begin slowing the economy before increases in inflation took hold. By acting quickly, the Fed would establish a reputation for being tough on inflation.
A self-reinforcing cycle would set in. Any evidence of creeping inflation would lead markets to expect a strong response from the Fed. Longer-term interest rates would rise in response to that expectation. That rise in longer-term rates would slow the economy and help stamp out the incipient inflation.
This conventional wisdom has been under attack for some time by economists who worry that it would keep inflation too low to allow the economic growth needed for a full recovery.
I agree. What the economy needs is a period of intense growth even if that growth happens to be mildly inflationary. And there's evidence that this message may be gaining sway at the Fed. In the minutes from its May meeting, the Fed stated:
A few participants commented that recent news on inflation, against a background of continued prospects for a solid pace of economic growth, supported the view that inflation on a 12-month basis would likely move slightly above the Committee's 2 percent objective for a time. It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee's symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.
In other words, periods in which inflation runs too low — beneath the Fed's 2-percent target rate — should be matched by periods in which inflation runs too fast.
If the Fed adopted that approach, markets would no longer believe that any sign of rising inflation would provoke the Fed to slow the economy. Only when average inflation has been above target for longer than it has been below target would the Fed be expected to raise interest rates.
Even more powerfully, this flexible view of the inflation threat would mean that if the economy slips into recession again and inflation falls, markets should expect the Fed to loosen policy and keep it loose long enough for inflation to make up lost ground. That expectation would lead to swift falls in long-term rates that would help the economy snap back faster. The possibility of the economy falling into a slow, painful recovery would be greatly reduced.
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