Fed Shouldn't Be Fighting the Last War
Recent public statements by some Federal Reserve officials were extremely disturbing, suggesting a backward-looking approach to policy decisions. In effect, these officials expressed support for the notion that interest-rate hikes should wait for inflation to hit the 2 percent target before any further increases. Such an approach ensures that the central bank’s policy will be late in containing faster inflation when it happens. It is far better to anticipate the need for change than to react to events after they have occurred.
Public statements by Neel Kashkari, president of the Minneapolis Fed, James Bullard, of St. Louis, and Chicago’s Charles Evans, suggest there should be no rate increases as long as inflation isn’t accelerating. (Kashkari goes further, as he has dissented from both of the Fed’s last hike decisions.) In each instance, a case was made that inflation is still benign and that no rate increase is justified until inflation pressures become overtly manifest. Instead, these policy makers wish to maintain low rates for as long as possible to promote job and economic growth, even as the unemployment rate is at exceptionally low levels. Each approach has risks, so let’s consider both.
With the unemployment rate at 4.3 percent, a historically low level, keeping interest rates down to promote growth is unlikely to accomplish much, because hiring becomes increasingly difficult as labor becomes scarcer.
Most economists and Fed officials already view the labor market as tight or even beyond full employment. On June 19, Evans stated that the “economy is performing well and we essentially have met our employment mandate” and Fed Chair Janet Yellen described the labor market as already at “maximum” employment. Unless there’s a meaningful slowdown in the pace of growth, the unemployment rate will continue to decline along its current trajectory. Last month, when the Bureau of Labor Statistics reported a “disappointing” gain of just 138,000 new jobs, hiring was almost double the underlying growth rate of the labor force of about 75,000 a month.
Moreover, BLS reports that job openings now exceed 6 million, the highest on record. So while companies are trying to hire more workers, fewer are available. This is a classic example of a tight labor market and wage rates are accelerating by most measures, albeit modestly so far. Even so, the unambiguous risk taken by keeping rates unchanged is that the labor market will tighten progressively and that employment cost pressures will continue to mount until they push up inflation, potentially sharply.
What are the risks if the Fed continues to hike rates slowly, as it has been doing? Growth isn’t particularly rapid, averaging about 2 percent over the past few years. If growth were to slow for whatever reason, a mild adverse shock might be sufficient to tip the economy into recession. Also, higher rates might slow the pace of economic and employment growth. None of these risks seem particularly worrisome at this point. If growth did slow, say to 1 percent, it would be reported in the data and the Fed could put its gradual rate normalization process on hold or even reverse it. And with the unemployment rate already at exceptionally low levels, less hiring might be welcomed to defer any significant upward pressure on inflation further into the future.
What seems to irk those who favor keeping rates unchanged is that the Fed has fallen short of its inflation target, even though it has fulfilled its unemployment mandate. This makes sense if both mandates are being targeted with great precision and need to be given equal weight. In fact, both targets are quite hard to hit. It has taken years to get the unemployment rate down to low levels, and inflation is not up to 2 percent despite the Fed’s efforts. But is a 25 percent shortfall in hitting the inflation target as problematic as being 25 percent above the Fed’s (unstated) unemployment objective? Numerically, wouldn’t we be more dissatisfied with policy if inflation already was at its 2 percent target, rather than today’s 1.5 percent, but the unemployment rate was a percentage point higher than 4.3 percent? A small deviation of inflation in the downward direction below target matters less than an unemployment rate proportionately above its target.
The policy dilemma is that if we push inflation to its 2 percent target by keeping rates down, it is quite likely we will send the unemployment rate even further below full, or “maximum,” employment. And unless we believe that the laws of supply and demand no longer apply, growing scarcity of labor must inevitably increase inflation. If so, we may find ourselves with inflation going right through that 2 percent objective and beyond. As Evans noted, a well-intentioned Fed that sought to promote full employment in the 1970s reaped excessively high inflation instead. In the latest minutes of the Federal Open Market Committee, “Several participants expressed concern that a substantial and sustained unemployment undershooting might make the economy more likely to experience financial instability or could lead to a sharp rise in inflation that would require a rapid policy tightening that, in turn, could raise the risk of an economic downturn.”
Indeed, the Fed risks repeating that experience if it fails to bring policy interest rates closer to neutral. Most likely, the Fed will increase the federal funds rate once more this year and also begin to allow its bond portfolio to roll off at a measured pace while it waits for inflation to increase, which remains the most likely result of its policies. But this requires the Fed to continue to be forward-looking and remain focused on the future path of the economy, inflation and unemployment and not be distracted by looking backward at the shortfall on hitting its inflation target so far.
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