Economics

How the Fed Turns Good News Into Bad

Events that lower inflation should allow the central bank to create more jobs. But it doesn't.

Positive shock.

Photographer: Christopher Furlong/Getty Images

Pop quiz! Are these events good news or bad news for the Federal Reserve?

  • China announces plans to build a lot more steel plants.
  • New innovation makes it possible to extract oil and natural gas more cheaply.
  • Robotics enhancements allow manufacturers to produce more output with fewer workers.

In principle, all would reduce inflation. With more steel capacity, there would be downward pressure on steel prices. With better extraction technologies, oil and gas prices would tend to be lower.  And robotics enhancements would weigh on both wages and prices.

This should be great news. It means that, at least over the medium term, inflation will be lower for a given level of unemployment.  So the Fed can generate higher employment without violating its mandate of keeping inflation at 2 percent.  Indeed, in the world of central banking it’s hard to think of any better news.

Yet that's not how I think the Fed would see it. Why? In order to achieve higher employment, the Fed would likely have to keep interest rates lower for longer than originally planned, or start a new asset purchase program. And I suspect that -- for whatever reason -- the Fed would be very reluctant to do so.

The Fed has been tightening monetary policy since May 2013, when then-Chairman Ben Bernanke announced its intention to begin tapering asset purchases. It has been doing so even though inflation pressures remain subdued, inflation expectations are near historical lows and prime-age employment remains well below 2007 levels. The Fed desperately wants more “normal” monetary policy, which means getting interest rates up closer to where they have been in the past.

By pursuing “normalcy," as opposed to its supposed goal of 2 percent inflation, the Fed can actually turn good news into bad. If, for example, the Fed failed to ease in response to any of the above-mentioned shocks, inflation would likely recede still further. That would reduce people's incentive to spend -- why buy something now if it's not getting any more expensive? -- and restrict economic growth.

Obvious as this may seem, central banks around the world seem unwilling or unable to ease monetary policy in response to disinflationary shocks.  The likely outcome is a world in which voters and their representatives increasingly perceive technological change and global business expansion as a threat to prosperity. That’s not a happy place.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Narayana Kocherlakota at nkocherlako1@bloomberg.net

    To contact the editor responsible for this story:
    Mark Whitehouse at mwhitehouse1@bloomberg.net

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