The Federal Reserve is balancing the wrong risks

This afternoon at 2 p.m., the coterie that decides American monetary policy will emerge from the bowels of the Federal Reserve to announce if interest rates will go up again. And as Tim Duy laid out in Bloomberg, the tug-of-war in their ranks is about the likelihood of rising inflation: Do they think it's just around the corner, or do they think a potential recession is a bigger worry?

It's a worthwhile question. But there's an even more fundamental one: Namely, how much can the economy heal? And not just from the Great Recession, but from the wage stagnation and job loss that workers have faced for decades?

To work through this, we'll need two different metaphors. The first is one you hear a lot from economists: The economy is like a car engine, and rising inflation is a sign it's overheating. Given the tools the Fed has to work with, it's not very good at hitting the gas until the engine runs hot. But it is very good at hitting the brakes — which intrinsically means slowing down job and wage growth as well.

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As Duy lays it out, the inflation hawks at the Fed think temporary changes in the global economy — cheaper imports from abroad and the plunge in the oil price — are hiding upward pressure on prices. They see slight upticks in nominal wages and inflation measurements, which say to them that as soon as temporary changes dissipate, inflation will shoot up. They're telling Fed Chair Janet Yellen to get ahead of the curve, and start applying the brakes now.

The doves, on the other hand, think those changes could be more long-lasting. They point to evidence that markets expect inflation to fall over the next few years, not rise. And of course, there's a thin line between low inflation and actual deflation — when prices fall rather than rise — which means recession. So they think the risks of not giving wage and job growth as much room as possible to recover are worse than the risks of failing to get ahead of inflation. They say step off the brakes.

Now, one thing Fed officials have traditionally relied upon to predict inflation is the Phillips curve. It's a rule of thumb that predicts that as the unemployment rate falls (which it's been doing) inflation will rise. Unemployment, in this understanding, measures the amount of "slack" in the economy — i.e. how much of the economy still hasn't been engaged. The idea is that once the economy is fully engaged, pouring more money into it won't do anything other than generate inflation.

But the Phillips curve hasn't been performing the way it should in recent decades. A big reason why is probably that unemployment isn't the only measure of slack. The unemployment rate is the percentage of the labor force that's working. But if years of lost jobs and stagnant wages have driven people out of the labor force, and if labor force participation isn't just falling because of more retirements or whatever, then there's more slack than unemployment alone will catch. There's also the question of how many people are working, but are working part-time because they want full-time work but couldn't find it.

This gets to the second metaphor. The economy isn't just an engine; it's also an ecosystem. It's made up of families and communities, as well as professional and personal ties. The people in it have to make certain choices when jobs are scarce, but they can make other choices when jobs are plentiful. This ecosystem can also repair itself when damaged. But this can only happen when we pour as much energy into the system as possible — which in the Fed's case means not pushing the brakes. We don't know how far this restoration can go, but the only way to find out is to push the limits and find out.

Even if inflation does start ticking up, how high can it go before it does damage? The hawks want to make sure inflation doesn't rise above the Fed's 2 percent target. But the economy performed just fine with inflation at 4 or 5 percent during the boom of the 1980s, for example. Economists' best modeling says that eliminating the remaining slack in the economy will raise inflation mildly, if at all. So overshooting the 2 percent target for a time seems a mild price to pay for a full-blown economic recovery.

Many of the inflation hawks at the Fed seem to live in a world where it's perpetually 1975, and inflation is on the cusp of rocketing up to 10 percent. But that world is gone. Income growth is neither strong nor widely distributed; unions have completely deteriorated, along with their ability to drive up wages (and thus prices); and rather than coming off a multi-decade stretch of tight labor markets, we haven't seen full employment in decades.

So the Fed should lay off the brakes, but not just because inflation isn't a big risk. It should lay off because we should be so lucky to even have an economy at risk of significant inflation again.