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One potential problem with the Fed’s vote to raise interest rates: The Fed might not know how the economy works

Outgoing Federal Reserve Chair Janet Yellen
REUTERS/Jonathan Ernst
Outgoing Federal Reserve Chair Janet Yellen and the FOMC majority see the current 4.1 percent unemployment as a sign that the economy is near its potential and thus the economy needs to slow down to keep unemployment from falling further.

Janet Yellen chaired her last meeting of the Federal Open Market Committee (FOMC) on Wednesday. The meeting, during which the members set monetary policy, went as expected. A majority of the committee voted to raise the Federal Reserve’s target range for short-term interest rates to 1¼–1½ percent.  And, as anticipated, Minneapolis Fed President Neel Kashkari dissented for the third time this year, arguing that there was no need for the Fed to raise interest rates.

Thus, for all appearances everything looks to be going smoothly as the Fed transitions from one chair to the next and continues to normalize monetary policy after the extraordinary actions it took after the 2008 financial crisis.

Unfortunately, things are not as calm and clear as they might appear. The Fed will soon have to face a problem: They don’t know what causes inflation and therefore don’t know what to do if it starts to rise or fall.

What causes inflation?

Perhaps I’m exaggerating. Economists know that high rates of money growth that are expected to continue for a long time cause high rates of inflation. Think of Weimar Germany in the 1920s, Russia in the early 1990s, or Zimbabwe and Venezuela in recent years.

We also know that there are two cures for this illness. One is to introduce a new currency, promise that the government will never engage in rapid money creation ever again, and then stick to that promise. Germany, for example, continues to follow this path. The other prescription is to take money creation out of the government’s hands and use another country's currency. For instance, Zimbabwe in 2009 stopped printing its own currency and told its citizens to use dollars or euros for business transactions.

Inflation and the Phillips Curve

U.S. inflation is nowhere near the levels of 1920s Germany or contemporary Venezuela. Since 2008, U.S. inflation averaged less than 2 percent per year.

Over the past two years, the Fed worried that inflation might start to rise above the 2 percent target and started raising interest rates to prevent this from happening. The theory behind this strategy is known among economists as the Phillips Curve. The idea works like this: Low unemployment signals that the economy is operating at or near its productive capacity. This, in turn, causes wages and prices to rise at faster rates, causing higher inflation.

Chair Yellen and the FOMC majority see the current 4.1 percent unemployment as a sign that the economy is near its potential and thus the economy needs to slow down to keep unemployment from falling further. The way to do this is to raise interest rates and put the brakes on spending by households and businesses.

The dissenters at Wednesday’s FOMC meeting, President Kashkari along with Chicago Fed President Charles Evans, argue that there are no signs of upward pressure on wages and prices and no indications that inflation is rising. Thus, the FOMC should wait until it detects these symptoms before raising interest rates.

But what if the Fed is wrong?

The FOMC is following the Phillips Curve logic, but there’s a big problem: The Phillips Curve might be wrong. Economists such as Stephen Williamson and John Cochrane point out that empirical models based on the Phillips Curve don’t fit the data and go on to argue that there is a very different process for inflation.

This view, known as Neo-Fisherism because it is based on a relationship first postulated by economist Irving Fisher, argues that the difference between interest rates that are not adjusted for inflation (what economists call nominal interest rates) and interest rates that are adjusted for inflation (known as real interest rates) equals the inflation rate. Thus, for a given level of real interest rates (determined by, for example, the profitability of capital investment), the inflation rate and the nominal interest rate move in the same direction at a one-to-one rate.

According to this view, the Fed is doing exactly the opposite of what it should be doing. To keep inflation low and stable, the Fed should be keep nominal interest rates low and stable. Instead, they are raising nominal interest rates and thus risking a higher inflation rate. Put more bluntly, if the Fed wants to keep inflation low and stable, they should follow the exact opposite policy of that suggested by the Phillips Curve.

The road from here

Right now, the danger of the Fed causing a spike in inflation is negligible. If the Neo-Fisherian view is correct, then raising interest rates by ¼ point won’t cause inflation to rise by more than that.  

The bigger threat is that the Fed is choking off the possibility of lower unemployment rates in a misguided attempt to prevent higher inflation. Thousands of Americans who might otherwise find work will find the way blocked by an excessively, and perhaps misguided, Federal Reserve.

Janet Yellen should leave a note for her successor, Jerome Powell, wishing him well as he and the FOMC navigate these currents.

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Comments (8)

While I am concerned that the Federal

Reserve doesn’t understand the economy, I am convinced 80% of our elected official at the Federal level don’t have a clue on how our economy works at either the macro or micro level. The liberals who believe pumping money to DC grows our economy are totally wrong. Take a look at the Obama stimulus package and ask yourself why it didn’t help? There was no structure in place to bring that 1 Trillion to the free market to stimulate the economy. That 1 Trillion went to the same programs that had billions in their budget already, went to unions and some just did the DC magic trick, it disappeared. That money was wasted,!!
Anytime elected officials claim you (the tax payer) keeping more of your own money is “Armageddon “ for the country, be very afraid. The Republicans are just about as bad. Pumping money to DC doesn’t work. Regular folks improve their lives when they get a better job, can get access to loans to start or expand small businesses (crushed by Dodd/Frank), manufacturing can compete world wide here in the USA, big business has incentive to expand here in the USA, we use our own natural resources here in the USA to lower costs and dependence on foreign countries. You very seldom hear this common sense approach to growing our economy. Unfortunately when you do it is called Armageddon.... Now that is clueless,!!

While you may want to claim a

While you may want to claim a trillion dollars was wasted (spending actually was closer to 800 billion), over 1/3 of that money went to tax cuts, less than a 1/3 to shoring up the safety-net, and less than a 1/3 to contracts, grants and loans (261 billion).

Seems to me that even a conservative should like the tax cuts portion and also understand the need to reinforce the safety net in the 2nd worst economic crisis in US history.

And while you may deplore every last line item of the final category, 261 billion dollars was less than 1/2 of one percent of the GDP in the 3 years of stimulus spending.

http://www.politifact.com/truth-o-meter/statements/2014/jan/30/rand-paul...

Neal, 80 % went to public sector unions.

Do you remember Obama laughingly saying “I guess shovel ready jobs were not so shovel ready”? There was no structure set up to get the money in the hands of those who create jobs. With the 1Trillion spent (congress got its hands on 787 billion). The Obama White House said our GDP would grow to 4.6% (didn’t come close),employment would sore (only thing that increased was folks quit looking for employment in droves) and our deficit would drop to 3.5% of our GDP (deficit went to 8.5% of GDP).

As I said I’m not sure about Fed understanding our economy but politicians surely don’t,!!

Well...

Seems to me all increased interest rates can do is generate more revenue for banks, and THAT has nothing to do with the general economy, it's just promotes more bubbles. Low interest rates are certainly better for consumers and ordinary people.

My personal experience, is that the last time we were really worried about inflation (back in the 80s) we had interest rates that were 10 X as high as they are now. Higher rates didn't control inflation then, I don't know why they would now?

Meanwhile, seems to me our inflation problems really began when we started nullifying the usury laws back in the 70s.

Besides the unknown and

Besides the unknown and overwhelming effects of climate change, the biggest hurdle facing the economy is the effect of the job losses due to automation and AI. There are studies that show up to 60 percent of the jobs can be replaced by technology already in the pipeline. We have been in the midst of the secular softening of the job market for several decades.

I really don't have any confidence that the effect of these changes has been grasped in relation to employment and productivity, inflation/deflation, and wealth concentration. The nature of jobs has also changed--people have a very light connection to their job and employment compared to the past--when was the first time you heard the phrase "digital nomad"? The other change that has occurred is the people "own" fewer things--they may make monthly payments for things from housing and cars to cable, internet and phone rental. This will make any future downturn or job loss even more catastrophic--the day you can't pay your rent--you're tossed out. The day you can't make your phone payment, you lose your connection to the modern world and economy. Shocks come quicker and displacement is deeper.

These are the issues I have little confidence that economists understand.

No one wants to talk realistically about this, except

...speakers in TED talks, Elon Musk, and a few others.

Why ?? Those in leadership roles have no idea what to do about it, as far as I can tell. They are whistling in the dark.

Some kind of minimum sustenance income is going to be necessary. Millions are going to be left behind as those who control the technologies you denote above will ride off into the sunset, never looking back until they realize they have destroyed the consumer base that is the foundation of their wealth.

If nothing is being done to address the effects, this one could make the last Great Depression look like a Sunday picnic.

And again....

"Economics" simply is NOT the scientific discipline it likes to pretend to be. It can be really difficult to sort out models based on reliable evidence and observations from those driven by ideological assumptions, and the field has a documented history of setting aside reliable evidence in favor of ideology.

On the other hand, I just read a different analysis suggesting that the REAL objective of these interest rate hikes is actually to put more Americans out of work, thereby raising unemployment rates and lowering pressure for higher wages.

Don't higher interest rates

Mean that the money in savings accounts , CDs, etc. grows faster? Seems like that would be better for ordinary people, especially retirees who have watched their savings dwindle due to inflation being much higher than the under 1% that they make from the bank.