Hoisted from the Archives: What I Wrote in Advance of the FOMC's September 2018 Meeting

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What a difference six months makes! And now the Fed really wishes it had not raised interest rates in the second half of 2018 and yet is unwilling to move them now back to the summer-of-2018 level. Why they are unwilling I do not know:

Hoisted from the Archives: Next week the Federal Open Market Committee—the principal policymaking body of the United States's Federal Reserve system—is overwhelmingly likely to raise the benchmark interest rate it controls, the Federal Funds rate that governs short-term safe nominal bonds, by one quarter of a percentage point from the range of 1.75-2% per year to the range of 2-2.25% per year. That would make it a little more expensive to borrow and spend and a little more attractive to cut spending and save. Thus there would be a little less spending in the economy, and so a few fewer jobs. Economic growth would be a little slower. The economy would be a little less resilient in the face of adverse shocks to resources or confidence that might generate a recession. These are all minuses—small minuses from a 25 basis point increase in the Federal Funds rate, but minuses.

Offsetting these minuses is supposed to be a plus: raising the Federal Funds rate by 25 basis points next week is supposed to lesson the chances of a disruptive upward outbreak of inflation. But I really do not see this plus as valuable enough to offset the minuses, even though they are small minuses.

This particular widely-anticipated move, however, will not shake the economy in any way: it is already baked into the cake in the sense that economic and financial decision-makers have already taken it into account and readjusted their portfolios and plans assuming it will come to pass. It is a continuation of the existing policy, another step on a well-marked path. The relevant question is: Is this the best policy path?

The Federal Reserve is on this policy path right now because the typical member of the Federal Open Market Committee (hereafter FOMC) believes that:

  1. The current 2% per year inflation rate is appropriate, and is a good choice for the Federal Reserve's target.

  2. The unemployment rate at 3.9% that is already so low that employers are having a hard time finding workers without offering wages that would accelerate inflation.

  3. With actual and expected inflation around 2% per year, the "neutral" Federal Funds rate is roughly 2.9% per year.

  4. When the Federal Funds rate is at the "neutral" rate, monetary policy is not putting pressure on the economy for either excess supply or excess demand in the labor market—there is pressure neither toward a situation in which employers increasingly have a hard time finding workers without offering them wages that would accelerate inflation nor toward a situation in which workers increasingly have a hard time finding jobs and sit pointlessly and destructively idle.

  5. Thus it is important that the Federal Reserve be moving the Federal Funds rate without hesitation from its current 1.75-2% per year to the "neutral" of about 2.9% per year.

  6. It is likely that the Federal Reserve should then keep raising the Federal Funds rate higher: the unemployment rate at 3.9% is probably too low to be sustainable without eventually generating rising inflation.

Of these six beliefs, (4) is essentially a definition of what the "neutral" Federal Funds rate is, and (5) and (6) then follow from (1)-(4) and the Federal Reserve's belief that its primary mission is to stabilize inflation at a low level, and not to seek higher employment levels when doing so would conflict with that mission.

The problem—or at least the problem as I see it—is that (1), (2), and (3) are all extremely debatable, and (1), that 2% per year is a proper inflation target, is surely erroneous.

I, at least, see (1) as surely erroneous because, as Jeffrey Frankel put it late last month: "In the past, the Fed has moderated recessions by cutting short-term interest rates by around 500 basis points. But, with those rates currently standing at only 2%, such a move is impossible..." Thus successful recession-fighting would turn on the competence, ability, and willingness of others to use the government budget to keep the economy on an even keel when the next recession comes. Yet there is unpleasant stabilization policy arithmetic that suggests a lack of ability to do so and even more unpleasant failure to learn the lessons of 2008-2018 that has produced a lack of willingness to do so. The only feasible plan to repair the situation would be for the Federal Reserve to raise its inflation target from 2% per year to 4% per year—the costs to the economy in the long run from returning to the inflation rates of the 1990s would be vastly less than the consequences of accepting the crippling of the ability to fight recessions.

But the Federal Reserve does not see it that way.

I, at least, see (2), that the unemployment rate at 3.9% that is already so low that employers are having a hard time finding workers without offering wages that would accelerate inflation, as not surely erroneous bur probably wrong. I think this for two reasons. First, while the unemployment rate is especially low today, the share of 25-54 year olds with jobs is not especially high. And as Adam Ozimek of Moody's reiterated yet again earlier this month, the 25-54 employment share and other wider measures of labor-market slack that see no high labor-pressure economy right now have done a better job of capturing the reality of inflationary pressures over the past generation. Second, the higher wage growth that we would be seeing in a high labor-pressure economy is not there. Employers are not yet willing to offer workers wages higher than last year's level plus inflation plus productivity growth. [Wage pressure is still markedly weaker][6] than it was at the last business cycle peak in 2007.

But the Federal Reserve does not see it that way.

And I, at least, see (3), the belief that the current Federal Funds rate is a full 1%-point lower than "neutral", as debatable. I would just note, as current Federal Reserve Chair Jerome Powell does, that the FOMC has steadily lowered its estimate of the "neutral" rate by fully 1.5%-points over the past five years. And I would also note that history shows us that there is a lot of momentum in the trajectory of FOMC estimates of the structure of the economy: the way to bet is that a process of revision in one direction or the other will continue. It is a committee, after all.

I could well be wrong. But I think it is more likely than not that, ten years from today, those on the FOMC will wish that they would have cut interest rates next week rather than raising them.

[6] https://blogs.uoregon.edu/timduyfedwatch/2018/09/10/monday-morning-potpourri/ "Tim Duy: Monday Morning Potpourri: 'A baseline expectation is that in a normal labor market, wage growth will be in the vicinity of real wage growth plus inflation.... Further labor market tightness should yield one of two outcomes–either real wages rise at the expense of profits margins or nominal wages and inflation rise in a lockstep pattern. The Fed would likely welcome the first outcome but would be unhappy with the second..."


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