Why The Fed Is Raising Interest Rates When Inflation Remains Low
The two pieces of economic news that were released yesterday (June 14, 2017) seemingly contradict each other: the Federal Reserve raised interest rates a quarter point, and the Consumer Price Index rose by less than two percent over the past 12 months. The Fed raised interest rates not because of the current inflation rate, but because of their expectations for the inflation rate in . . . 2019.
Bill Conerly based on Federal Reserve data
Fed Funds Rate and projected change
The Federal Reserve Board and the regional Federal Reserve bank presidents mostly have a model in their heads—and in their computers—in which time lags are substantial. Rounding broadly, there is a one-year time lag between actions taken by the Federal Reserve and effects on spending, production and employment. Then there is another one-year time lag until inflation rises or falls. This is the greatest challenge that the Federal Reserve has. Milton Friedman famously said that the time lags in monetary policy are long and variable.
It is as if you had to turn your car’s steering wheel two blocks before you wanted the car to turn. But sometimes it was just a block and a half early, and at other times it was two and a half blocks early. Heaven help the pedestrians. And heaven help those of us who rely on a healthy economy for our incomes.
This description is an oversimplification, of course. There will be a few spending and production impacts fairly quickly, then more impacts in the 6-to-18 month time horizon, and then some final small final impacts up to two years away. The same is true of the inflation time lag.
Although the time lags are variable and not precisely measured, the fact that there are time lags is solid.
The argument for expecting inflation to become a problem is pretty strong. The labor market is very tight, suggesting that we’re trying to produce more than we have the capability to produce. Rising wage rates will be a signal that overall prices are too low.
Those people at the Federal Reserve are not as crazy as they may appear to be.
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