Between a Rock and a Hard Place

What would you rather have? Exactly three onions a week for your Sunday-night onion soup, no matter the price you pay? Or you’d rather do without the soup for a few weeks, as long as the price of onions remains stable over time?

Let me rephrase the question: Would you rather have stable prices for whatever you consume but find yourself in and out of jobs as the economy fluctuates? Or you’d prefer to keep your job most of the time, but see prices rise so frequently that you can’t be sure whether you’ll be able to afford your dream Caribbean holiday next winter?

These are the kind of dilemmas the Fed battles with on a daily basis. Especially recently, as the ghost of “stagflation” has returned to haunt us. Stable inflation or stable growth and employment? As much as we’d like to have both, life often involves trade-offs and the trade-off between inflation and economic growth is one of them. Or is it?

In the long-run… In the long-run we’re all dead, the world returns to equilibrium and, actually, there is no trade-off between the level of inflation and unemployment.

Mind you that’s not what policymakers thought back in the old days. At the time, they liked to entertain the idea that they could cut interest rates to spur growth and job creation, at the cost of just somewhat higher inflation—nothing wrong with inflation at 4 percent instead of 2!

But didn’t they learn better! Turns out the sustainable level of employment is determined by “real” factors such as technological change and productivity, the nature of labor market institutions or population changes. So if the Fed cuts rates to lift employment beyond the sustainable level, all it will achieve is spiraling inflation…

The lesson? In the long run, the Fed would better aim at keeping inflation low and leaving growth and unemployment alone.

No trade-offs, no problem? Not exactly. Many (though not all) economists believe that a trade-off does exist. But the recent buzz is not about the level of inflation and unemployment; it’s about the trade-off between how much each of the two changes—i.e. how volatile they are.

In this universe, life turns out to be a simple, downward-sloping line: As you slide down the line, you’re basically making a choice: Happier stomach or happier wallet? Parking space, front yard but with suburban routine, or “sex in the city” pizzazz but squeezed in a cubicle of an apartment?

Crucially, volatile inflation or volatile growth? Attempts to stabilize one makes the other more volatile. The implication is that, if a shock hits, a Central Bank like the Fed might not want to leave growth alone in the short-run: Instead, it might choose to tolerate rising inflation for a while, to avoid abrupt changes in growth and employment.

This is especially the case because prices tend to be “sticky”: They respond slowly to, say, a drop in demand. So while inflation today may be high enough to suggest immediate Fed action, this may be deceptive: Underneath the surface, firms may be preparing to lower their prices in response to falling demand, and you’re ready to accept zero pay rise, to avoid losing your job.

So how tough is the Fed’s dilemma these days? Turns out that some shocks pose more of a dilemma than others. And the shocks today seem to belong to the “more” category on all counts. Let’s see why.

Demand or supply? Demand shocks tend to be easier to deal with than supply shocks. Suppose we suddenly found ourselves with more money—for example because of an error in the measurement of money supply or because the Martians unloaded tons of greenbacks from a giant helicopter. So we begin to buy more things, growth rises above its sustainable level and prices go up.

The due direction of policy looks unambiguous: The Fed should raise rates to bring growth back to sustainable levels and also lower inflation. Yet a trade-off still exists: How aggressively should the Fed raise rates? Is it worth bringing inflation down fast, if the cost is much slower growth?

Still, it can get worse. Think of a supply shock—like a rise in gas prices to the “unheard of” level of $4 a gallon. Inflation obviously goes up, since oil and energy more broadly are part of our consumption basket. But this time output goes down, since people have less disposable income to spend on other (made in America) stuff.

While the due direction of policy is “up” to stop inflation from rising (remember?.. no Fed impact on growth in the long run?), the Fed is now torn: With growth already falling, it would like to be more subtle with rates. But that comes at the cost of higher inflation for a while, possibly together with higher inflation expectations…

Temporary or permanent? A second complication has to do with whether a shock is temporary or permanent. If oil prices shoot up because a hurricane damaged a few oil rigs in the Gulf, you can reasonably assume it won’t last too long; and the Fed can just sit and watch.

But what if oil prices keep on rising with a dumbfounding determination? At some point, they are bound to start seeping into the rest of the economy. But, gosh, isn’t it reasonable to think that the more they rise, the closer they are to “leveling off”? And with demand falling, could the Fed have a case for “waiting to see”? But for how long? What if prices are “getting ready” to rise but we have not seen it yet because they are sticky?

Starting from bliss? Another complication is that, in most theoretical analyses of the optimal course of monetary policy, the starting point is “equilibrium”: The economy is operating at its sustainable employment level and inflation lies near the Central Bank’s target. But what if the starting point for growth is the “emergency room” after, say, a crash in the housing sector and the financial markets? How do you deal with an oil price shock on top of that?

Where’s the line? Finally, truth be told, the downward-sloping line remains a theoretical concept. So even if it exists, its precise shape, slope and position cannot be known with certainty at all times. And that’s a problem: If the Fed sees an increase in inflation volatility, there are at least two ways to interpret it: It could either be because it has been too lenient on inflation; or because the line itself has shifted—say due to a permanent rise in the volatility of global energy and food prices as demand and supply conditions have become tight. The former might require aggressive Fed action, while the latter less so.

So hey, after reading all this, you might want to show some sympathy for Ben and his crew, and the sleepless nights they spend trying to find the right recipe. Because, admittedly, onion soup with a single onion just doesn’t taste as good..

Originally published at Models and Agents and reproduced here with the author’s permission.