Four Ways to Think About the Economy
I see four different schools of thought about how the economies of the U.S. and much of the developed world should be managed. The challenge for the Federal Reserve and other central bankers is that it's hard to know who's right.
Let's call the first group of economists the neutralists. They would say that as long as inflation is low and stable, central banks can have only a modest and short-lived effect on variables such as jobs and economic growth. They think that the media pay too much attention to monetary policy, leading government officials to ignore more important questions, such as how to make the economy more productive.
A second group, the inflationistas, worry that demand for workers is already starting to push up wages, giving rise to an inflationary spiral that central bankers will have a hard time getting under control. Because changes in interest rates take a while to flow through to the economy, they think the Fed is already behind the curve.
Then there are the bubblers. Like the neutralists, they're skeptical about the efficacy of monetary policy. Many would even say that inflation is being driven largely by technological and demographic forces outside central banks' control. They believe that low interest rates are generating unsustainably high stock and bond prices and encouraging dangerous amounts of borrowing, setting the stage for a financial and economic disaster.
A fourth group -- the gappers -- think economic activity is still well below the level that would generate excessive inflation, even though central banks have long been holding interest rates very low in an effort to boost activity. To support their claim, they note that inflation remains below central banks' targets, and that measures of longer-term inflation expectations remain low. Some gappers argue that central banks should pursue new forms of stimulus, such as taking interest rates negative or directly financing government spending. They would also say that, if central banks can’t or won’t provide the needed stimulus, fiscal authorities should do so instead -- an argument that provokes the inflationistas and also many neutralists, who believe that government is already too big.
So who's right? Actually, given the available evidence, I don't think that it is possible to discard any of these views as being obviously false. This means policy makers will have to act on the assumption that they could all be right.
The neutralists are correct that we should consider ways to improve the economy's longer-term growth potential. We might, for example, be able to enhance human capital with a different approach to financing college or to educating pre-K children.
Inflation could be imminent. In my view, though, the Fed shouldn’t address the inflationistas' concerns by choking off growth now. Instead, the central bank should be clear about its willingness to raise rates sharply once "core" inflation (a measure that excludes volatile food and energy prices) has risen in a sustainable way above the 2 percent target.
If the bubblers are right about artificially inflated asset prices, that doesn't necessarily mean that an ensuing bust has to severely harm the economy. True, that's what happened during the financial crisis of 2007-2009 -- but largely because monetary and fiscal authorities didn't do enough to reflate the global economy rapidly. Policy makers should be readying themselves to do better next time around.
The gappers are demonstrably right that inflation and expected inflation are too low in the developed world. On this front, there's plenty that monetary and fiscal authorities can do. Further stimulus would help, at least some, to boost what remains a profoundly disappointing economic expansion.
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