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Employment is high. But inflation is back, thanks to Federal Reserve | Peter Crabb

What choices are you going to make? And what will be the costs?

It’s one of the most fundamental truths of economics and life in general: W e all face trade-offs. The costs of such choices can be substantial, and sometimes our choices cause harm to others.

The Fed continues to make a choice with harmful consequences.

In January 2012, Federal Reserve policy makers adopted what they call the “Statement on Longer-Run Goals and Monetary Policy Strategy.” This policy states that 2% inflation each year is consistent with the Fed’s congressional mandate to promote a “full” employment.

Historically, full employment was considered to have been reached when unemployment” was between 5% and 6%. Last month, the national unemployment rate was reported as 5.8%.

Peter Crabb
Peter Crabb

Even though unemployment is falling into its normal range, the Fed is choosing to keep both short- and long-term interest rates low, reasoning that the benefits exceed the disadvantages of prices rising by 2% or more per year. The theoretical trade-off is known at the Phillips Curve.

English economist A. W. Phillips published a report in 1958 that showed a negative correlation between inflation rates and unemployment. This empirical relationship was later confirmed by U.S. economists using data from the 1960s.

But a decade after Phillip’s finding, Nobel Prize-winning economists Milton Friedman and Edmund Phelps showed that such policy trade-offs were good only for a short period, if at all. In the long run, low interest rates have no real effect on the economy.

It’s not too surprising that the Fed cannot influence unemployment over time. The number of workers who can’t find work depends on many factors beyond bank rates, including labor productivity and the rate at which new businesses arise.

The U.S. Bureau of Labor statistics recently reported that there are approximately 9.6 million job openings and 9.3 million Americans out of work and looking for work. While it is true that not every open position will match someone looking for work, it is fair to say the U.S. economy is at or near full employment. Meanwhile, the same bureau reports that U.S. consumer prices rose 5% over the past year, and 5.4% in Western cities like Boise, Idaho.

So, what’s the harm of the Fed’s policy choice?

Economic theory and historical evidence show a number of costs to society from rising prices, including the increased variability of relative prices, unintended changes in tax liabilities, and the arbitrary redistributions of wealth between debtors and creditors.

The last of these is most prominent today. With positive inflation, the Fed’s low-rate policy benefits the young over the old.

For example, a college student taking out a $10,000 school loan today at 7% annual interest will owe about double the amount in 10 years when the loan comes due. But the real value of this debt will be much less, because inflation lowers the purchasing power of money.

Meanwhile, those households with savings in the bank earning 1% or less — primarily the elderly — earn a negative real rate of return after inflation. Low-interest-rate policies are like a tax on the elderly.

We all face tradeoffs, a battle between choices. But the Fed is fighting the wrong battle and hurting many in the process.

Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. prcrabb@nnu.edu

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