Some of the reasons people have given for why the Fed should keep raising interest rates make sense to me, and some don’t.
I have to say that the line of reasoning from the Wall Street Journal takes the cake:
The Fed’s Open Market Committee decided not to raise interest rates again — not because inflation is contained but because it says the economy is slowing. Uh, oh. Here we go again, back to the era of the Phillips curve, the economic theory that postulates a trade-off between inflation and unemployment. We thought Paul Volcker and Alan Greenspan had buried that notion years ago. But apparently it lives on like Arthur Burns’s ghost in the attic of the Fed, ready to inhabit a new Chairman who has inherited an inflation and is afraid that breaking it will send the economy into recession.
To me, there is a basic question here that can be settled without appeal to ideology or consultation with ghosts. Surely the relevant question for an objective observer is the following: if the unemployment rate goes up or the rate of growth of real GDP slows down, should that cause a rational person to anticipate a lower rate of inflation than you would have predicted in the absence of those changes?
Harvard Professor James Stock and Princeton Professor Mark Watson, two of the nation’s most careful and respected economic researchers, conducted a very thorough investigation of how well different models succeeded for purposes of forecasting inflation in an article published in the Journal of Monetary Economics in 1999. They compared Phillips-Curve specifications based on measures of the level of real activity such as the unemployment rate or the growth rate of industrial production with alternatives that included 19 different interest rate measures, 12 different measures of the money supply, 21 different price or wage indexes, and a number of other variables. Here was their conclusion:
The major conclusion of this study is that the Phillips curve, interpreted broadly as a relation between current real economic activity and future inflation, produced the most reliable and accurate short-run forecasts of US price inflation across all of the models that we considered over the 1970-1996 period. This conclusion will come as no surprise to applied macroeconomic forecasters in business and government, where the Phillips curve plays a central role in short-run economic forecasting. The conclusion is also consistent with the recent academic literature on short-run economic forecasting.
Mark Thoma raises another important issue for the WSJ to consider. Basically, the Fed had just one choice here, namely, whether to raise the fed funds rate or hold it constant. We all agree that pausing is likely to mean a higher inflation rate over the near term than would a raise. But if inflation is the only concern, then why not raise the fed funds rate arbitrarily high to get an even lower inflation rate? Surely the reason we don’t want to raise interest rates arbitrarily high is that there are other consequences of higher interest rates, namely slower economic growth or a possible recession, that we worry about as well as being concerned about taming inflation.
A rational evaluation of the current situation calls for weighing the risk of higher inflation against the risk of an economic downturn. The Wall Street Journal may have a different evaluation of the size of these risks or place a different weight on the importance of avoiding one outcome or the other relative to Bernanke.
But the fact that Bernanke calls attention to an economic slowdown that is already underway is surely relevant for this discussion, no matter what your intellectual paradigm.