Fed’s Brainard: Breakdown in inflation-unemployment relationship poses challenge

© Reuters. Federal Reserve Board Governor Lael Brainard speaks at the John F. Kennedy School of Government at Harvard University in Cambridge© Reuters. Board Governor Lael Brainard speaks at the John F. Kennedy School of Government at Harvard University in Cambridge

WASHINGTON (Reuters) – The relationship between slack in labor and other core resource markets and inflation has “broken down,” posing risks for the Federal Reserve if it fails to lift the pace of price increases to its announced target, a top Fed official said on Thursday.

Fed Governor Lael Brainard said the behavior of inflation, with unemployment at a 50-year low, was both “puzzling,” and a problem if households and businesses lose faith that the Fed will meet its 2% target.

“The trend in inflation … appears to be somewhat below the Federal Reserve’s goal of 2%,” Brainard said. “This raises the risk that households and businesses could come to expect inflation to run persistently below the Federal Reserve’s target and could change their behavior in a way that reinforces that expectation,” a difficult spiral to break.

The Fed is undertaking a year-long review centered around strategies for meeting the inflation target and addressing the weakened relationship between low unemployment and price increases. Under standard thinking, unemployment below a certain level, by raising incomes and wages, leads to higher inflation.

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Among the remedies Brainard suggested would be to allow any future spike in prices, a sudden rise in import costs for example, to continue without a Fed response.

That “opportunistic reflation,” she said, could “communicate that a mild overshooting of inflation is consistent with our goal.”

She said the breakdown of the “Phillips curve” tradeoff between low unemployment and higher inflation also added to the case for stronger bank capital buffers and other regulatory steps to ensure financial stability.

Low unemployment is allowing workers to make gains, Brainard said, and the Fed does not want to interfere with that.

But continued low interest rates do add to risks of financial bubbles developing. Rather than raise rates to guard against financial sector problems, she said, tools like higher bank capital buffers could be relied on.

“Today’s economy is providing opportunities for workers who might previously have been left on the sidelines,” said in prepared remarks to the National Tax Association. “Adding financial stability concerns to the burden of conventional monetary policy might undermine sustained achievement of our employment and inflation goals.”

Other Fed officials have so far resisted Brainard’s call to use a “counter cyclical capital buffer” to require banks to raise capital during good times.

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Source: Investing.com