The Fed's inflation experiment is both intriguing and distressing

The Fed's inflation experiment is both intriguing and distressing
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A serious limitation of macroeconomics as a discipline is that controlled experiments are difficult to conduct. That is why economists should welcome the Federal Reserve’s decision to effectively test whether the Phillips curve theory still holds by allowing the U.S. economy to run at a very much faster rate than is sustainable over the long run.

Whether or not economists should endorse the Fed’s decision as good policy is an entirely different matter. This is especially the case since the Fed’s dovish approach to interest rate policy raises the probability of a hard U.S. economic landing down the road.

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According to the Phillips curve theory, as unemployment falls, wage and price inflation should increase. Moreover, it should do so at an accelerating rate once unemployment reaches very low levels.

 

Evidently, judging by the Federal Open Market Committee’s (FOMC) latest economic forecast, the Fed now believes that if the Phillips curve still holds, it does so in the mildest of ways. Seemingly, the Fed now believes that the economy can be run hot for a long time period without inflation raising its ugly head.

One striking feature of the FOMC’s latest economist forecast is that it envisages the U.S. economy growing faster than its long-run potential growth rate over the next few years. Specifically, it sees the U.S. economy growing by 2.7 percent in 2018 and by 2.4 percent in 2019. It does so even though it estimates that the economy’s long run potential rate of growth is only around 1.8 percent.

A more striking feature of the FOMC’s latest forecast is what it has to say about unemployment. It is now saying that unemployment will decline steadily from its present rate of 4.1 percent to 3.6 percent by the end of 2019.

At the same time, the Fed is holding onto its belief that the “natural” rate of unemployment, or that unemployment rate below which inflation accelerates, is around 4.5 percent. This implies that the Fed will be allowing the economy to operate at beyond what it itself considers to be full employment for an extended time period.

Yet, despite forecasting that unemployment will stay well below the natural rate for a prolonged period of time, the Fed is taking a benign view on the U.S. inflation outlook.

It is now forecasting that the core personal consumption deflator, its favored inflation measure, will only increase from its present 1.5 percent rate to 2.0 percent over the next two years. By so doing, it is effectively saying that if the Phillips curve is not dead it looks to be on life support.

As an economist, I have to hope that the U.S. economy is not thrown off course by something like a trade war and that it is allowed to overheat as the FOMC’s forecast now seems to be suggesting. That will allow us to establish once and for all whether the Phillips curve has finally died in the U.S. economy.

However, as a private citizen I have to say that I have serious reservations about the Fed’s approach. I fear that the Fed’s experiment with allowing the economy to overheat will prove that the Phillips curve has merely been dormant and that inflation will turn out to be very much higher than that level for which the Fed is bargaining.

If that turns out to be the case, we should brace ourselves for a hard economic landing. Once markets perceive that the Fed is behind the curve in containing inflation, we must expect that the bond vigilantes will come out of the woodwork and drive up long-term interest rates.

That in turn risks roiling today’s frothy financial markets, which are presently priced to perfection.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.