Fed’s Dilemma in Low Inflation and Job Gains

Feb 9th 2015

 Federal Reserve Announces End of Quantitative Easing


Nowadays, the Fed faces with the severe dilemma between low inflation and job gains. The unemployment rate has fallen to 5.7% from 6.6% a year ago and 8% two years ago while the inflation rate is still below the target 2% rate. According to Wall Street Journal, the stronger job market provides reason of raising short-term interest rates to prevent the overheating market while low wage growth and inflation show the signal that overheating problem wouldn’t be in the near future.

Officially, the Fed already said a high possibility of raising short-term interest rate around the midyear. However, many Fed officials worry about the market situation although net hiring increases during the November-to-January by more than 1 million. Their worries come from the inflation which is still below the Fed’s 2% objective and little wage growth. Why does low inflation matter? It is a simple economic theory called Phillips curve. Basically, it phillipsis a historic inverse relationship between unemployment rates and inflation rates in the economy. In theory, there is a point where the long-run Phillips curve meets the short-run Phillips curve, where the Fed and other governments target on.



“Economists call this cutoff point a non-accelerating inflation rate of unemployment, or Nairu, and also point to a “natural rate” of unemployment where inflation is stable in the longer-run. The problem is nobody knows the cutoff point. Economists merely estimate it” (Wall Street Journal). Because of uncertainty in estimating the point, it is hard to set the interest rate at the right time. Both Fed officials and policy makers want to see the obvious sign to make sure that the economy is close to the full employment, but not as much as to the overheating point.

There are two options for Fed; it can be patient until the market shows a clearer sign or take an action by increasing short-term interest rate. Personally, I am in the position that Fed should wait because I think raising the interest rate is too risky. As Rosengren said, “Low level of inflation in most developed economies meant the U.S. central bank shouldn’t hurry to raise interest rates.” Furthermore, still the economic measures are not fully recovered as before the sub-prime mortgage. For example, many people point out involuntarily part-time workers, which make “job gains” doubtful. “There are still almost 7 million workers counted as employed who say they are working part-time involuntarily” (Wall Street Journal). Fed should be more careful about its increasing interest rate unless the whole economy falls into the deep recession again.

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