Counterplan solves inequality without increasing financial risk or inflation

Douglas Elmendorf, “Using Fiscal and Monetary Policy to Reduce the Harmful Effects of Inequality,” Remarks delivered by Dean Douglas Elmendorf at Ten Big Ideas on Inequality, Harvard Kennedy School, 10-13-16, https://www.hks.harvard.edu/more/about-us/leadership-administration/offices-deans/deans-office/presentations-and-papers/using-fiscal-and-monetary-policy-to-reduce-the-harmful-effects-of-inequality

In sum, low unemployment has very important advantages for people who are lower on the economic and social ladder. Can we achieve low unemployment through monetary policy and fiscal policy without creating larger economic problems? Yes.

For monetary policy, the willingness of the Federal Reserve to keep interest rates low for an extended period has been a very positive force. If the Fed had raised interest rates 2 or 4 or more years ago, as some commentators were urging, we would not have seen the strong demand for workers that has given many people jobs, kept many in the labor force, and created faster wage growth.

The two possible negative consequences of low interest rates that have received the most attention are higher inflation and greater risk in financial markets. But those possible consequences have not materialized in an important way. Inflation remains below the Federal Reserve’s target, as it has been for nearly a decade. Indeed, an increase in inflation now would be good, in part because it would raise market interest rates and give the Fed more room to cut rates when the next recession hits. Of course, inflation might rise so much that the Fed would need to slow the economy—but people who have focused on that danger in recent years have been like generals fighting the last war.

Risk in financial markets is somewhat higher than it would be without low interest rates, but it is not especially high. Asset prices have increased considerably, and the resulting spur to consumer spending and investment is part of how low rates boost economic growth. That increase in asset prices does raise risk, but the greatest dangers can be addressed by regulatory policy. For example, rapidly rising prices for commercial real estate led regulators last year to warn lenders about the dangers of lax lending standards, and in response to that warning and their own assessments, lenders have tightened standards for commercial real estate loans.

Therefore, the Federal Reserve should not rush to raise interest rates now but should instead allow the unemployment rate to fall further. And when the next recession arrives and unemployment starts to move up, the Fed should cut the federal funds rate from whatever level it has reached down to zero if necessary. If that cut is not enough to keep unemployment low, the Fed should again use quantitative easing and other measures. Although those newer tools are less familiar than changes in interest rates, the differences involve the mechanics of policy and not fundamental principles, so we should not let their relative novelty deter us.