Here is an article that appeared in the New York Times on 11/12/99. There is concern that, with the economy as strong as it is now, shortages will develop which will drive up wages and then prices (read the article to get a feel for the mechanism). Why should the Fed worry about this? After all, our theory predicts that as long as the Fed doesn't let money growth get out of hand, any rise in prices due to shortages can only be temporary. No need to worry about a take-off in inflation, certainly. So, why is the Fed worried about the inflationary consequences of a potential rise in prices?

  One answer lies in the expectation trap idea I discussed the other day. It works like this. The Fed is sitting here now, thinking that a price or two may rise any day now that the economy is so strong (shortages here and there make this inevitable). It thinks that people seeing these price increases will jump to the conclusion that  inflation is taking off. That is, they see that P today is 10 percent higher than P yesterday, and reach the conclusion that this is a new trend, which will continue indefinitely. At least, the Fed is worried that this is how expectations will respond to observed rises in prices.

  The Fed is afraid that if it does not act now to weaken the economy and prevent the rise in prices from occuring in the first place, then it risks finding itself in an uncomfortable dilema down the road a bit. They are afraid that if they take the road of inaction now, then they will eventually be forced into having to pick one of two very unattractive choices: either validate the expectations of high prices by expanding the money supply (i.e., fall into an 'expectations trap'), or not validate these expectations and thereby produce a recession (this was described in lecture). They don't want to end up with this dilema. The article suggests that they are likely to take a different road in the upcoming FOMC meeting, one where they head off the inflationary pressures now, before they show up directly in the data.

  There are two things to think about, in this context. The strategy of taking action now to be 'ahead of the cuve' on inflation now is itself a dangerous one. After all, in tightening the money supply to slow down the economy now, they could actually trip it into a recession. Second, fundamentally, the reason that the road of inactivity is also a dangerous one is itself due to Fed policy. People understand there is a good chance that if inflation expectations rise, the Fed will feel obligated to accommodate them. That's because everyone understands that part of the Fed's legal mandate is to be a 'good guy' and take good care of output and employment. After all, no one would ever imagine in the first place that a rising price signals a takeoff in inflation if they didn't think there was a good chance the Fed would accommodate. So, fundamentally, the reason there is a policy problem at all lies with the Fed's reputation of caving in when the going gets tough. If it didn't have this reputation, then the Fed wouldn't have any reason to slow down the economy when it was strong. The irony here is that it's fundamentally the Fed's reputation for being a good guy that will likely force it to be a 'bad guy' at the next FOMC meeting.