What should the Federal Reserve do? The case for opportunistic inflation

Sometime next year, the Federal Reserve will likely face an unusual confluence of economic circumstances. One of its mandates, full employment, will call for monetary policy to tighten relatively quickly; the other, inflation, will suggest it should stay loose. How should the Fed weigh these competing goals? It may want to dust off a doctrine from the 1990s, “opportunistic disinflation” and rechristen it “opportunistic inflation.”

Today’s mirror image would be “opportunistic inflation”: exploit any overheating in the economy as an opportunity to push inflation higher. If unemployment does fall to 5% next year, that should have two beneficial effects for the labour market. First, it should push up wages. Hourly earnings rose 0.4% in November, an unexpectedly brisk and long overdue increase. But they are still up just 2.1% from a year earlier. Since profit margins are so wide, it will take several years of stronger wage growth to generate cost-push inflation. Second, some of the long-term unemployed who have quit the labour force should be drawn back in, reversing some of the loss of potential output brought about by the prolonged period the economy spent depressed.

To get inflation higher requires a negative output gap by allowing unemployment to fall below its natural rate for a time. That may happen even on the current plan in which interest rates start to rise slowly from zero in 2015

http://www.economist.com/blogs/freeexchange/2014/12/what-should-federal-reserve-do?fsrc=nlw|newe|8-12-2014|

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