"Most economists determine whether the economy needs stimulus by comparing current and projected unemployment rates with a measure called the Nairu—the nonaccelerating inflation rate of unemployment (sometimes called the natural rate of unemployment). That number is supposed to mark the dividing line between unemployment so high that it pulls inflation down and unemployment so low that is pushes inflation upNow my graphical explanation.
Trouble is, nobody knows where the Nairu is today. The FOMC is acting under the assumption that today’s 4.1% unemployment rate is below Nairu, which it currently pegs at 4.5%. That could be right. But a year ago the committee thought Nairu was 4.7%, and three years ago it pegged it at 5.1%. The estimate kept falling because inflation stubbornly refused to rise despite low unemployment.
Here’s my own view, but it’s no more than an educated guess: The unemployment rate has settled at 4.1% for six months now, and inflation is creeping up very slightly. That suggests a Nairu in the 4% to 4.5% range, just a pinch lower than what the Fed now believes. But remember, the Fed keeps lowering its estimate.
Now to the second question: With the federal funds rate in the 1.5% to 1.75% range today, is monetary policy stimulating the economy or restraining it? To answer that question in the past, economists have compared the real interest rate—the funds rate minus inflation—to another key dividing line: the neutral (or natural) real interest rate, which Wall Street calls r* (pronounced “r-star”). Here’s the idea: When the real federal funds rate is above r*, that means money is “tight,” the Fed is holding back demand and inflation should fall. When the real federal funds rate is below r*, money is “loose,” the Fed is pushing demand up, and inflation should rise.
But where is that dividing line today? That’s a complicated question, because r* depends on many factors beyond the Fed’s control. If any of those other factors change, so will r*. The most prominent example today is fiscal policy, which has recently changed quite a lot due to large tax cuts and a bipartisan spending spree. These developments have presumably pushed the neutral interest rate above the Fed’s semiofficial estimate made last fall, which was 0.4%.
Where are we today? The federal funds rate is at 1.7%, while inflation is at 2% and inching up. This means the real federal funds rate—the difference between those two metrics—is slightly negative and thus almost certainly below the neutral rate, though perhaps not by a huge amount. The Fed’s current monetary policy is therefore still slightly stimulative"
"When I was the Fed’s vice chairman in the 1990s, we felt we had a reasonable handle on the Phillips curve: If unemployment rose by 1 percentage point for a year, that would knock about half a percentage point off the inflation rate, plus or minus. That rule of thumb worked pretty well back then. But not lately.
Since 2000, the correlation between unemployment and changes in inflation is nearly zero."
The more money in the economy, or the lower the interest rate, the more demand for all goods and services, holding all other factors constant (this total demand is called aggregate demand or AD). The price level in the economy and the total output or quantity produced in the economy is determined by the interaction of AD and aggregate supply (in this case I am interested in something called short-run AS or SRAS-so yes there is a long-run AS but that is not the important issue here although in the long run we will come back to QF with even more inflation if we go past it in the short run).
The full-employment GDP (QF in the graph below) is the level of GDP that gives us the natural rate of unemployment. If we move from AD1 to AD2, we will still have very small price increases while having a big increase in GDP which will help lower the unemployment rate. But if we go past AD2 (if interest rates get too low), then we get much bigger price increases than for AD increases to the left of QF. So we want the Fed to set interest rates so that we are at AD2. But no one knows for sure if we are at AD2 or not.
The SRAS also keeps getting steeper since inefficiency increases as we get closer to (and beyond) QF. As inefficiency increases, costs increase faster and faster. This gets passed on to the consumer in the form of ever faster increases in prices. The slope has to get steeper to reflect this. The inefficiencies come in partly because we keep bringing less efficient resources into production the more we try to produce.
If a company has 4 idle factories and demand picks up, it brings the most efficient of the four back online, then the next one, and so on. The demand for resources might be increasing at an increasing rate.
Fed Officials Disagree On Threat Of Inflation (from 2009)
Fed Chair Janet Yellen: "there remains considerable slack in the economy" (from 2014)