Head to head: Federal Reserve should focus monetary policy on inflation control

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Over the past several years, the American economy has faced a tumultuous crash, subsequent recovery process and a struggle to avoid dipping back into recession. It’s been a busy time, to say the least.

While stock market indexes such as the Dow Jones Industrial Average and the S&P; 500 have recently reached all-time highs, unemployment levels remain bloated, sitting at 6.1 percent in the latest Bureau of Labor Statistics report for June 2014.

The lack of jobs is the real problem facing Americans today and is one of the major components that is holding us back from completely revitalizing our economy. After all, if people don’t have jobs, they can’t buy goods and services from businesses, and if businesses can’t sell their goods and services, they close shop and lay off employees, furthering the vicious cycle of joblessness and poverty.

Unemployment, according to the widely-used Keynesian model of economics, is closely tied to inflation. Inflation, which is the rise in average prices of goods and services usually compiled in a “consumer price index,” essentially measures the cost of living in certain areas.

Inflation, when controlled, is a sign of economic growth and an indicator that businesses are expanding at a healthy, sustainable rate. Deflation, on the other hand, is a sign of a stagnant or recessing economy; falling prices signal negative economic growth, which is never a good thing for employment levels.

Although it seems counterintuitive, rising prices are often a good thing for the economy and the average person because rising prices mean that businesses are growing. When businesses grow, not only do they make more money to pay their employees with, but their need for additional workers also increases. Hence, the Keynesian model: as inflation increases, unemployment decreases.

Janet Yellen, chairwoman of the U.S. Federal Reserve, gave a speech at the International Monetary Fund on July 2 saying that the Fed needs to focus on employment rather than financial stability. In a way, she’s right. Unemployment problems, however, will be solved through achieving financial stability.

The Fed’s main role in the U.S. economy, and perhaps its most widely recognized responsibility, is the stabilization of the nation’s financial markets and banking systems. Another role, however, as listed on the Fed’s website states that it is also responsible for “conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices.”

Note how the terms “pursuit of full employment” and “stable prices” are tied together. This is because a healthy inflation rate is paramount to returning to the employment levels of the early 2000s which usually sat below four percent. Pacing inflation increases at a healthy, controlled rate can be tricky. But, if done at the correct levels, it can be a catalyst for economic stimulus.

The Fed needs to continue to focus on addressing monetary policy in such a way that inflation rates increase in a controlled manner, which will lead to a decrease in unemployment. Using monetary policy as the main tool, the Fed can control the rates at which banks can lend and borrow money out into the market. This rate, called the “Federal Funds Rate,” can have a drastic effect on inflation.

When this rate is reduced, for example, banks can offer loans at much lower interest rates. This causes a surge in demand for these loans, which results in increased economic activity leading to higher wages, higher prices and more optimistic earnings expectations in financial markets.

The Fed needs to continue focusing on monetary policy to solve our employment issues. This economy is in dire need of a revolutionary innovation that will kick start production and growth. Until then, however, monetary policy will play a large role in driving down unemployment. If the Fed wants to have a shot at creating jobs, it needs to make sure that there is enough cash flowing to and from businesses to encourage growth.

Free cash flow will free up money for research and development, investment in potential innovation and the ability to spend more on production, wages, etc. The Fed can’t hope to come in and solve all of our economic problems on its own. Instead, it must do everything in its power to provide business with enough financial support to solve their own problems.

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