The Federal Reserve's pitched battle with rising prices has given rise to widespread concerns about a possible return of "stagflation" — the combination of high unemployment and high inflation that afflicted the U.S. in the 1970s.
Actually, a bit of stagflation is just what the Fed should be — and appears to be — aiming for.
Monetary policy acts with a lag. If a central bank wants inflation to be lower a couple years in the future, it must raise interest rates now, to generate the decline and slack in consumer and labor demand needed to slow growth in prices and wages.
The appropriateness of a central bank's policy should therefore be judged in light of where it expects unemployment and inflation to be. It shouldn't, for example, plan to miss its targets in opposite directions — a policy rule known as "Qvigstad's criterion" (after the Norwegian central banker Jan Qvigstad).
For example, if unemployment were to remain elevated after inflation has already fallen below the targeted level, monetary policy has been too tight, inflicting more economic pain than necessary.
Logical as this all might be, it has a perhaps surprising implication. If the Fed is doing its job right, it will push up the unemployment rate before inflation declines, and both inflation and unemployment will remain elevated until they reach their targets.
In other words, the Fed should be seeking to achieve a period of stagflation.
Judging from the Fed's most recent economic projections, a small amount of stagflation is exactly what it's going for. The median forecast, which assumes successful monetary policy, projects inflation and unemployment about 0.3 and 0.4 percentage points above their targets, respectively, at the end of 2024.
While Qvigstad's criterion offers no guidance on what the relative size of unemployment and inflation misses should be, it appears that the Fed views a roughly one-for-one trade-off as appropriate.
Granted, the Fed's forecasts tell us nothing about how it might respond if the economic outlook worsens. If, for example, officials decide that supply disruptions will be more persistent than previously thought, will they stick to the one-for-one tradeoff — allowing, say, inflation and unemployment to pass through 5% and 7% on their way to their targets? How much stagflation is the central bank willing to tolerate?
This is a crucial policy question that the Fed needs to answer publicly.