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Winning on inflation could mean Yellen lets U.S. economy run hot

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(Bloomberg) — WIN: “Want Inflation Now”.

During her almost two years as head of the world’s most influential central bank, Janet Yellen has had a difficult time driving up one thing she directly controls: inflation.

Today’s lack of pricing power stands in stark contrast to the 1970s, when a soaring consumer prices prompted the Ford administration to launch a program known as WIN — “Whip Inflation Now”.

During Yellen’s tenure, the annual rate of change on prices has averaged 0.8 percent — far short of the Federal Reserve’s 2 percent target. Oil has fallen 69 percent since the end of January 2014, wages have been slow to accelerate and the dollar’s 22 percent rise has made imports cheaper.

Additionally, a host of technological disruptions — from Amazon to Uber — have helped curb pricing power. By giving consumers information on what they’ll have to pay for goods and services, these innovations are spurring competition to keep costs low.

While these forces are beyond the Fed’s control, the risk of inflation taking too long to return to target is starting to worry central bankers. Some officials called the decision to raise rates last month “a close call,” particularly given the uncertainty about inflation dynamics, according to minutes released Jan. 6.

Right now, the Fed’s strategy is to wait and hope the effects of cheap oil and import prices wash out. By the end of 2018, inflation will be back on target, their forecasts say.

But the waiting game has risks. A new, lower level of inflation expectations could become entrenched in the economy. What’s a central banker to do?

Go slower

Fed officials could forgo another rate increase in March, a possibility reflected in futures markets where the probability of no change at that time is around 58 percent.

A pause would fuel expectations of a much slower series of rate hikes than the four that policy makers projected for 2016. Short- and long-term interest rates would drop, resulting in cheaper financing costs that could further stimulate demand in an economy where the jobless rate is already at a seven-year low of 5 percent.

Still, the strategy is riskier than it sounds. The Fed estimates the jobless rate that is consistent with steady price pressures is around 4.9 percent. Foot-dragging on interest rates while labor-market slack continues to diminish could mean Fed officials fall too far behind on their policy setting.

If inflation climbs faster than expected due to the pickup in demand, central bankers will have to raise rates at a quicker pace, “and that increases the risk of a recession,” said Laurence Meyer, a former Fed governor and president of LH Meyer Inc. in Washington.

Fiscal policy

Fed chairs typically steer clear of advising the legislative branch on spending. Yet if the monetary policy lever is less effective, fiscal expansion is an obvious choice, said Laurence Ball, an economics professor at Johns Hopkins University in Baltimore.

“In the short run, to boost output, we need more demand, which means we need somebody to be spending more money,” Ball said. “The surefire way to have somebody spend money is to have the government spend it.”

For example, increased outlays on infrastructure projects could help put more Americans to work, giving them income to spend and boosting demand. Similarly, if legislators agreed to abolish the payroll tax for a year, “that would be a big tax cut for everybody that would expand the economy a lot,” Ball said. He added that in the current election-year gridlock, such a policy is “politically unrealistic.”

An increase in the federal minimum wage, which has been at $7.25 per hour since 2009, may also be unrealistic. Yet such a boost would help stimulate incomes and spending, said Ethan Harris, co-head of global economic research at Bank of America Corp. in New York.

In 2014, 3 million workers earned wages at or below the federal floor, representing 3.9 percent of all hourly paid workers, according to the Bureau of Labor Statistics.

“Most studies suggest small changes in minimum wage have small employment damage and have a significant impact on the income of low-income people,” Harris said in an interview. “It’s not like it’s going to create a lot of inflation, though. We’re talking a tenth or two here.”

Run hot

Another strategy Fed officials could deploy would be to let the economy run hot and challenge their assumptions about where full employment lies.

“Test the limits of growth, but with a little bit of hedging,” said Angel Ubide, a senior fellow at the Peterson Institute of International Economics in Washington.

The strategy is partly in place in the Federal Open Market Committee’s outlook. The economy is seen growing 2.3 percent to 2.5 percent this year, above its 2 percent potential, while unemployment averages 4.7 percent in the final three months.

The personal consumption expenditures price index, minus food and energy, rises to 1.5 percent to 1.7 percent in the fourth quarter. That compares with a 1.3 percent gain from a year earlier in the third quarter of 2015.

Ubide said the committee should gradually raise rates as joblessness falls, not accelerate the pace of tightening even if unemployment drops below 4.9 percent.

This strategy suspends belief in theories and models about where inflation kicks in at a given jobless rate. Instead, it looks for proof that prices are climbing while moving rates higher so as not to fall behind.

“The best solution, given the uncertainty, is to take the middle road,” Ubide said.

See also:

Retired 20-somethings cloud Yellen’s crystal ball on job market

Payrolls surge, U.S. jobless rate at 5 percent as workforce grows

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