Not yet, Janet: America’s still not ready for a higher target rate

A common observation of my blog by readers is the fact that I don’t oftentimes take strong positions on the issues I discuss.  At first,  I took these comments with great pride, because being impartial and presenting multiple possibilities to a question is the defining hallmark of the economics profession.  President Harry Truman once remarked: “Give me a one-handed economist! All my economics say, ”On the one hand, on the other…”.  But, as the Truman quote suggests, this is not always a splendid thing.  People want precise answers and opinions; and although I do oftentimes think in ways that incorporates both sides of an argument, I am not without biases of my own.  So to mix it up a bit, I’m going to prominently infuse those biases into the posts I make.

And what a perfect time to do so, because policymakers (particularly of the monetary kind) have some big decisions to make soon.  The context can be painted as the following: the American economy is finally operating close to (or much closer to) its productive capacity.  Official employment is almost “full” (with U3 at 5.5% in May), and wages are finally beginning to rise at a faster clip (nominal wages are up 2.3% year-over-year in May, the fastest since 09′).  But inflation remains very subdued, with year-over-year core PCE and CPI inflation rates still hovering between 1 and 2% (below the Fed’s 2% target).  The Fed, under the direction of chair Janet Yellen, has indicated (currently and historically) that it’s target for the Federal Funds rate (the key rate on overnight bank loans) will be raised once these thresholds are approached.  But there’s a few reasons why I think it needs to wait longer:

1) Historically, inflation hasn’t spiked when unemployment fell below its estimated “NAIRU” rate.  As noted elsewhere on this blog, as the U.S. economy reaches it’s productive capacity (equilibrium), this is likely to push up wages as employers compete more for a scarcer supply of workers. This helps to produce “wage-push” inflation; businesses hike prices to pay for higher wages (at least partially), and workers use their higher wages to push up aggregate demand in an economy already producing at capacity.  These capacity constraints also help to produce the “too much money chasing too few goods” explanation of inflation.  This means that, theoretically, we should see a rise in inflation very soon.

Except we probably won’t.  Why?  Due to historical experience and the readings of several other economic indicators, I don’t think the economy is actually near full capacity yet.  In other words, our estimates of the non-accelerating inflation rate of unemployment (NAIRU) are too high.  The experience of the 1990’s (as elaborated on by Jared Bernstein and Dean Baker) provides support for this view.  Near the end of the decade, unemployment plummeted – from 5.6% in 1995 all the way down to 4% by year 2000.  NAIRU estimates for the year 2000 were consistently higher than the actual unemployment rates achieved; starting at 5.4% in 1994, those estimates actually increased to 5.8% in 1996 before dropping back down to 5.2% by year 2000.  In other words, economists expected inflation to start accelerating once U3 unemployment reached and fell below these rates.  Yet, as the charts below demonstrate, inflation (especially PCE less food & energy) barely budged during the 1990s – and actual unemployment rates were far below NAIRU estimates!  Part of that was no doubt due to the late 90’s productivity spurt, but productivity is still growing at a decent (if not stellar) clip right now, meaning more output can be produced with a given (or less) amount of input.  As more output can be squeezed out of given inputs, there is less of a need to raise prices to maintain profitability.  If now is anything like the late 90’s, productivity growth can absorb wage growth/cost pressures for a while before businesses will have to raise prices to maintain profits.  In other words, unemployment could fall a ways further from its current 5.5% rate before we start to see inflationary pressures, which means that our current NAIRU estimates (around 5-5.5%) are too high.  This would make sense; I feel like, ever since the 1970s hyperinflation episode, policymakers have been overly cautious in making sure that policy tightening begins before inflation gets too high.  Thus the artificially high NAIRU estimates.


Source: “The Unemployment Rate at Full Employment: How Low Can You Go?” by Jared Bernstein and Dean Baker.


Source: “The Unemployment Rate at Full Employment: How Low Can You Go?” by Jared Bernstein and Dean Baker.

Additionally, there are the countless other indicators that suggest the economy is still being underutilized.  The more comprehensive U6 unemployment rate, which, as the BLS describes, measures “…total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force”, still stands at 10.8% in May 2015 (seasonally adjusted).  The employment-to-population ratio has also yet to recover from the recession, standing at 59.4% in May 2015 (down from a cyclical high of 63.4% back in December 2006).

2) It’d be good to have a long period of low unemployment after the disastrous labor market of the past few years.  As everyone (especially recent college graduates) knows, the job market hasn’t been stellar for a while; it’s only just getting back to “normal”.  U3 hit a 3-decade high of 10.0% as recently as late 2009, the U-6 measures were even higher, and worst of all, long-term unemployment as a share of the unemployed hit both a record high and stayed high for a record amount of time (see chart below).  Such high rates of unemployment for such long periods of time undoubtedly have helped destroy millions of household finances over the years while also threatening to create structural unemployment (as skills atrophy and people become less “employable”).  I think, like a yo-yo, such high and extended periods of unemployment should swing the opposite way: exceptionally low unemployment for an exceptionally long period of time.  This will aid households in naturally repairing their finances (which did appear to actually “improve” over the years, but it seems personal bankruptcy and/or exceptionally painful (destructive?) saving were the main reasons).  It will allow workers to practice their skills and boost their self-esteem (which can create a virtuous cycle of higher productivity).  Additionally, it can also help to generate wage pressures so wages can “catch up” the ground they lost (as in, the growth that would have occurred had the economy been operating at full capacity since 2007).  Some might argue that this could threaten profits too much; however, coming at the heels of several years of record profits and high volumes of cash reserves, I think employers would be able to healthy absorb wage hikes for a fairly long period of time before this became an issue.

3) Continued loose policy would help counteract an over-appreciation of the dollar.  The U.S. dollar has gained rapidly against a basket of currencies since last fall (up by a full 21% against the Euro since this time last year).  There are many reasons for its rapid rise – a collapse in oil prices, investor confidence in the strength of the U.S. economy, and – ironically enough – investor expectations of a target rate hike.  The concern is that either this appreciation continues or that its rapid rise has already done too much damage.  Stronger currencies make exports more expensive (by boosting the relative prices of exporters and decreasing their competitiveness) while simultaneously making it relatively cheaper to import.  Though the latter is good for consumers, the combination of lower exports and higher imports wreaks havoc on the trade balance (which, for America, is almost always in deficit), thereby lowering GDP growth.  Arguably one of the biggest forces restraining the dollar from rising much further is a continuation of loose monetary policy.  End it, and the dollar rise alone could stall a still rather mediocre recovery (by historical standards).  Along with the other reasons above, it’d be preferable to continue a low target rate at least until some of the other pressures are alleviated.

4) Even if it did threaten to raise inflation a bit above current targets, this wouldn’t necessarily be a bad thing.  Look, too much inflation is bad.  Everyone knows that rising prices squeeze family budgets and distorts economic decision making (shifting future demand into the present to avoid higher future prices, leading to a negative feedback loop of higher inflation).  It’s literally a hidden (or not-so-hidden) tax that eats up the purchasing power of savings and investments.  But a little bit of inflation is not a bad thing.  Stable, fairly low inflation can actually benefit an economy.  It makes wages less sticky by placing pressure on employers to raise them (so employees can maintain cost-of-living).  By lowering the purchasing power of dollars spent on repaying fixed-amount burdens, it also reduces the real debt of indebted consumers who, after becoming extremely over-leveraged during the 2000s, could still use some relief so they can resume healthy (but moderate) spending.  This reduction in real debt burdens also goes for the federal government (whose $18 trillion tab, while manageable in a $17 trillion economy, could still use some relief).  Inflation a bit above the current target of 2% (say, 3 or 4%) would still be manageable; and in my opinion, is absolutely worth it if low unemployment can be attained.  Now, this does present a credibility problem for the Fed; it’s consistently stated that 2% target figure, and if inflation were to rise higher than that, then it could spook investors and lead to concerns that the Fed will not contain it (and that another Weimar Republic-style meltdown is on its way).  So perhaps the Fed should inform investors of a new, slightly higher target rate, while making it clear that absolutely no higher rates will ever be tolerated.  It might help to remind economic agents that these targets didn’t even exist as recently as 40 years ago, so it’s hardly like they’ve remained consistent.

5) A recession can still be handled by both fiscal and monetary policy, even if rates start out at zero.  So what if the Fed can’t lower nominal rates any further?  They have Q.E. and a general unlimited capacity to purchase securities, emergency lending capabilities, operation twist, forward guidance, etc., etc.  And there are tens of thousands of governments in the United States that theoretically have the capability to engage in expansionary fiscal policy (though the Federal government, with its unique status of having no balanced operating budget requirement, will probably remain the most potent public sector actor).  If you raised rates now and caused a recession, you probably still wouldn’t be able to cut them that far anyway (since they probably won’t reach that high before equilibrium is breached).

6) Savings rates were plummeting anyway…and the boost to equities is (arguably) still good.  Due to a myriad of factors (wage stagnation, cultural shifts, a global savings glut, etc.), Americans no longer save the way they used to.  Indeed, in 2005, the savings rate went negative for the first time since the Great Depression, and in recent years has only climbed back up to around 5%.  Too many trends outside of the Fed’s control will continue to keep downward pressure on savings rates.  And there’s no guarantee that a rise in the effective Fed Funds rate would necessarily translate into higher interest rates for savers (in savings accounts, C.D.’s, etc.)  Additionally, the effect of the Fed continue to purchase securities to maintain a low effective Fed Funds rate is to lower the yield (and boost the price) of bonds/securities, making equities relatively more attractive (for their higher returns).  This has allowed the stock market to soar, bolstering the “wealth effect” for households (prompting them to spend more) and increasing the returns to retirement accounts tied to the equity markets.  And we can’t forget the impact of low rates making long-term borrowing (e.g. for mortgages) easier, translating into higher house prices (and thus greatly boosting the wealth-effect for the middle class).

Overall, then, the argument against raising rates now is clear.  Now granted, the target rate will have to be raised eventually (probably within the next year or so) – these positive effects will not last forever, and there is a risk of overshooting targets and objectives if rates stay low too long.  But it’s time to break from the past policy hyper-conservatism and boldly declare a new approach; today’s challenging economic environment requires nothing less.


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