Opportunistic overheating

WHEN officials at the Federal Reserve meet next week, they will wrestle with a problem most other central banks would love to have: what to do if unemployment gets too low?

The question is not hypothetical. America’s labour market is on a tear. Non-farm employment rose by an impressive 321,000 in November, the most in nearly three years. Job growth is not only strong, it is accelerating, averaging 241,000 this year, up from 194,000 last year. The unemployment rate, at 5.8%, is down 1.2 points in the past year. Within a year, at that pace, unemployment could drop below 5%. At such levels, the Federal Reserve reckons, firms struggle to find workers and so start to offer higher wages. Inflation soon follows.

To be sure, the labour market is not fully healed. Wages have risen by only a paltry 2.1% in the past year, though they flickered to life in November. Nonetheless, the improving picture means the Fed may soon signal that it is open to raising interest rates from zero, where they have languished since 2008. Although it recently brought its bond-buying programme (known as quantitative easing) to an end, it has pledged since 2012 to keep interest rates near zero for “a considerable time”. At their next meeting, which finishes on December 17th, the central bankers may drop that phrase or replace it with something vaguer.

Bolstering employment is only half the Fed’s mandate; its other duty is to keep inflation near 2%. Yet since the Fed made that its target in early 2012, it has persistently fallen short (see chart). The $50 drop in the price of oil since June is likely to send headline inflation below 1% next year, reckons HSBC, a bank. The stronger dollar is also playing a part, by making imports cheaper.

The Fed has often faced contradictory pressures from unemployment and inflation. In late 2012 Janet Yellen, then the Fed’s vice-chairman (she is now the chairman), ran a simulation to determine what policy would best balance the two. It concluded the Fed should hold interest rates at zero until 2016 to hasten the fall of unemployment, though that would temporarily push inflation above 2%. That exercise helped establish Ms Yellen’s reputation as a dove. But her staff reran the exercise last month and concluded that with unemployment so much lower, the optimal policy is to start raising rates immediately, even though inflation is below target.

The Fed’s apparent willingness to tighten with inflation so low rests on the assumption that it will slowly return to target thanks to a tightening labour market and stable expectations of inflation. The central bank is also inclined to ignore the impact of oil prices as transitory, much as it did when oil shot up in 2009.

That may be too sanguine. A paper by Olivier Coibion of the University of Texas at Austin and Yuriy Gorodnichenko of the University of California at Berkeley found that the jump in oil prices in 2009 may have had a much bigger impact on inflation than is generally believed. They reckon that given the rise in unemployment, inflation should have fallen to around zero in 2009-11. It did not, they say, because oil placed upward pressure on expected and actual inflation.

By the same token, the latest drop in the oil price may also leave a surprisingly deep imprint. In recent months a market-based measure of expected inflation in five years’ time has dropped from 2.1% to 1.6%, according to Barclays, a bank. That is a bigger fall than the one that has occured in the euro zone, which is flirting with deflation. The measure should be relatively immune to the gyrations of the oil price. Yet Fed officials have downplayed its decline.

The risk is that inflation becomes entrenched at its current, lower level. This will not matter when the economy is growing, but when the next recession comes along, it will cause problems. Interest rates cannot fall below zero, since savers would simply convert their deposits into cash. If inflation is 2%, real rates can fall as low as -2%. If it is only 1%, however, the lowest they can go is -1%, which may not be low enough. Indeed, it has taken more negative rates than that to bring America’s economy back to its present state of health.

Low-cost insurance

The Fed could insure against such an outcome by letting unemployment fall below 5% for a time. By putting upward pressure on both wages and prices, that would not only push inflation back to target, it might also draw back into the labour force workers who dropped out because job prospects have been dismal for so long. This would be the mirror image of “opportunistic disinflation”, the strategy the Fed pursued in the early 1990s. At the time, inflation was too high and the Fed exploited periods of high unemployment to ratchet it lower. Opportunistic inflation simply means exploiting periods of overheating to ratchet inflation higher.

Lingering with rates at zero is not without pitfalls. Inflation could, against all expectations, rebound suddenly and force the Fed to push rates up rapidly, roiling financial markets. Furthermore, many argue that rock-bottom zero is fomenting dangerous imbalances. Speculative froth is already widely visible: many stocks are trading at dizzying valuations; the bonds of risky companies and countries are trading at only slightly higher yields than safe government debt.

The Fed could mitigate both risks with a strategy of “soon but slow”: raise rates a token amount as scheduled in mid-2015, then signal that it will drag its feet on subsequent moves. That would remind speculators not to take zero rates for granted, and give the Fed a modest head start if inflation roars back. Whatever strategy it chooses, the risk the Fed must keep front and centre is of falling back into a trap of negligible inflation and zero interest rates. Were that to happen, full employment would once again slip out of reach.