Speaking at the Austrian Economic Forum, Janet Yellen, President of the Federal Reserve Bank of New York, confirmed that the Federal Open Market Committee (FOMC) will indeed implement rate hikes once the unemployment rate falls below six percent. She stated that the Fed has “big goals” to achieve, which includes increasing inflation. Yellen’s comments echo those of Fed Chair Ben Bernanke, who has said that with an unemployment rate above six percent, the board will take action in January.
He also said that policy makers will be interested in seeing unemployment fall to a level that is consistent with its dual mandate of maintaining price stability and promoting full employment. Yellen’s comments indicate that the Federal Reserve is focused on meeting this objective. Nonetheless, there are risks associated with monetary tightening:
First, there is the risk of a self-fulfilling prophecy. An improvement in the underlying health of the economy may prompt policymakers to act because they view it as a signal of better times ahead. However, they may find that rising inflation leads to higher rates, pushing interest rates even higher. As a result, the economy will fall into a worse situation than it was before they tightened monetary conditions.
Second, there is the risk of economic malaise. Inflation rises, which leads to higher interest rates. With lower rates, there is less financial risk to banks. This ultimately means lower profits for the banking sector, which can cause them to close their doors.
Third, while financial institutions will receive more loans and more capital if the inflation rate increases, their business models may change. If they have many loans, but little profit margin, the liquidity they have available may dry up, making it difficult for them to withstand a high interest rate environment. Banks may also default on their loan obligations.
Fourth, a weaker dollar may cause financial institutions to cut back on their investments or even stop lending. That would worsen the situation. It could also force banks to reduce their lending. It’s hard to see how monetary tightening would be helpful in this regard.
Fifth, inflation can fall far below the target level. When this happens, it is better for the Federal Reserve to relax its monetary policy. The Federal Reserve may be able to stay afloat without reducing interest rates too much. But it would be better for the economy if it tried to reach its inflation target.
Six, there is the risk of financial instability caused by falling inflation. A deflationary spiral can set in, where consumers lose confidence in money-market funds or savings accounts, causing banks to liquidate them. It’s hard to see how monetary tightening would help in this regard.
Seventh, there is the risk of political strife in the United States over monetary policy. Monetary policy in America is highly politicized, with the Federal Reserve having a strong lobby in Washington. While the Fed has been doing its job, politicians in Washington have chosen to abuse their power and influence over monetary policy.
Eighth, the inflation rate may fall far below the target level. When this happens, it’s better for the Federal Reserve to ease monetary policy. There is little incentive for policy makers to raise interest rates in an environment where the central bank is allowing inflation to fall to zero.