After all, notice that the red and green regions of the bull’seye chart show modest inflation above 2 percent is much more acceptable than even 6 percent unemployment. The FOMC should be anxious to get to that bull’s-eye region as quickly as feasible given the long slow path to date. The Fed’s reaction function I’ve spoken so far about how we are missing on our policy objectives. Obviously, the aim of policy is to eliminate those misses. How do we hit the bull’s-eye? What do we do 6  BIS central bankers’ speeches  operationally in terms of policy tools? In normal times, the FOMC moves it’s traditional policy tool, the federal funds rate, in order to influence aggregate demand and with it economic growth and inflation and disinflationary pressures. Many economists have studied the relationship between actual Fed actions and sensible, explicit policy rules that might capture the Fed’s policy reaction function (chart 4). Historically, Fed policy moves have been reasonably well described by simple policy rules, particularly the 1999 version of the so-called Taylor rule, 7 that relate the federal funds rate to the differences of output (a proxy for employment) and inflation from their target levels and a constant term that is meant to capture the equilibrium real interest rate and the Fed’s inflation target. However, this rule does not always describe policy well. For example, given judgmental, but reasonable, choices for the Fed’s inflation objective before it adopted a 2 percent objective, the Taylor rule misses during the 1990s are big.

Without appealing to esoteric economic theories of sunspots, these expectations don’t seem sustainable in the current environment. Higher inflation expectations would presumably get priced into higher bond-market yields and higher financing rates generally. Until inflation actually rises – remember, this story has expectations rising first – ex post real interest rates would be higher and that would presumably result in a higher debt burden for borrowers. This would reduce aggregate demand. Lower demand and lower growth would further reduce cost pressures, strongly suggesting that higher inflation expectations would not be ratified by inflation experience, and thus, would not be sustained. Frankly, this story just seems very unlikely. Fourth, another more direct measure of potentially rising costs and hence inflation might be stronger wage growth. The economic story here is a bit involved. Most economic research indicates that rising wages are not a leading indicator of rising inflation, so wages are rarely an early warning signal for future inflation. However, higher inflation would lead to higher nominal wage growth. And the double-digit inflation experience of the 1970s suggests that inappropriately accommodative monetary policy can amplify rising cost pressures, creating a wage–price spiral. Clearly, unsustainably strong nominal wage increases would very likely be symptomatic of rising inflation pressures. In terms of the current situation, there is good news and bad news. The good news is that currently, wage increases are low and not symptomatic of high inflation. The bad news is that, currently, low wage increases are symptomatic of weak income growth and low aggregate demand.