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:

Source: “The Unemployment Rate at Full Employment: How Low Can You Go?” by Jared Bernstein and Dean Baker. http://economix.blogs.nytimes.com/2013/11/20/the-unemployment-rate-at-full-employment-how-low-can-you-go/?_r=1

Source:

Source: “The Unemployment Rate at Full Employment: How Low Can You Go?” by Jared Bernstein and Dean Baker. http://economix.blogs.nytimes.com/2013/11/20/the-unemployment-rate-at-full-employment-how-low-can-you-go/?_r=1

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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A Spring Cleaning for American Monetary Policy

The past several months have witnessed profound transformations in the state of America’s economic outlook. Output growth has accelerated, with annualized GDP growth rates of 4.6%, 5.0%, and 2.2% in Q2, Q3, and Q4 of 2014, respectively.  This has been accompanied by similarly impressive gains in the pace of job creation, with a full year’s worth of monthly net employment gains of over 200,000, and an unemployment rate increasingly dipping into “natural rate” territory (estimated to be between 5.2 & 5.5%, though recently revised to around 5.1%).  Oil prices have plunged since late 2014, helping to spur aggregate demand.  And the FY 2016 budget released by the Obama administration in early February continued the turnaround in federal fiscal policy, with large increases in proposed discretionary spending initiatives promising to accelerate (if implemented) the transition towards a more accomodative policy stance.

Real GDP Growth has trended upward in recent quarters.  Photo courtesy of the Bureau of Economic Analysis.

Real GDP Growth has trended upward in recent quarters. Photo courtesy of the Bureau of Economic Analysis.

Monthly net payroll growth has steadily increased as output growth has accelerated

Monthly net payroll growth has steadily increased as output growth has accelerated

The U3 unemployment rate measure is slowly converging towards the estimated natural rate of unemployment (NAIRU).

The U3 unemployment rate measure is slowly converging towards the estimated natural rate of unemployment (NAIRU).

All of this points towards an economy that is rapidly strengthening and should continue to do so as the year continues.  The impacts of oil & natural gas price declines have yet to fully ripple through the economy in the form of increased manufacturing competitiveness and higher consumption.  Firming employment figures should boost aggregate demand as more earnings are recycled into discretionary household purchases.  Higher stock and housing prices will continue to translate into “wealth-effect” consumer spending.  And rising retail sales should further spur investment, boosting current and long-run growth in the process.  Ceteris paribus – all else held equal (such as geopolitical happenings) – and there is little reason to expect for strong economic growth not to continue.

With the arrival of Spring on March 20th and the accompanying wave of household cleaning, as well as this unexpected barrage of good economic news, it is a good time to take stock of the current policy trajectory.  Considering it is in the news so much, and bears so much direct import on the macroeconomy, of primary concern is the stance of monetary policy.  How soon should the Fed tighten?

Currently, the main policy tool that is modulated by the Federal Reserve, the Federal Funds Target Rate, is set in a range from 0 – 0.25% – the lowest levels in its history.  This has been the case since late 2008, and the 6+ years since then has likewise marked the longest period of accomodative policy in history.

This is set to change.

Rumor has it that a long-awaited hike in interest rates (read: Fed Funds Target Rate) will proceed by the middle to late-middle of this year, though the rate of increase will be fairly gradual, perhaps around 50 basis points to .75% by late this year.  This has been the assumption of investors for awhile now, and seems to be the likeliest course of action.  But is it a good course of action?

My views are mixed, but side with pessimists who feel that even these gradual steps are too rapid.  First among my concerns is that the American economy is still no where close to “full employment”, one of the key elements of the Fed’s dual mandate.  The Economic Policy Institute estimates that U3 rates closer to 4.0% (instead of 5 – 5.5%) are more consistent with NAIRU (n0n-accelerating inflation rate of unemployment).  This would make sense, for though unemployment is now within reach of the Fed’s estimates for NAIRU, inflation has continued to trend down (turning into outright deflation in recent months as lower oil prices feed into general prices), and wage growth remains stagnant (at 2% nominal growth, real wage growth is too low to feed into wage-push inflation).

fredgraph

Rates of inflation are well below the Fed’s 2% annual target

 

Nominal Wage Growth Tracker

As demonstrated by the Economic Policy Institute’s Nominal Wage Tracker, wages are rising too slowly to be consistent with target wage and inflation growth.

 

We would expect wage growth to strengthen as we near the natural full rate of unemployment.  Rising demand for workers while the labor supply becomes more scarce boosts the bargaining power of workers to negotiate higher wages.  This wage growth is partially a pre-requisite for higher rates of inflation (closer to the 2% target).  Higher wages means that prices usually must be increased for businesses to maintain profits, and these higher prices then necessitate further wage hikes, creating a positive upward spiral that feeds into rising inflation.  Since both nominal wage growth and inflation rates are well below target, it appears that full employment has not yet been reached.

Some will argue that the existence of monetary policy impact lags (how long it takes for a policy change to have an effect) would justify a rate increase now, as several months from now, it may well be that full employment is reached and wage and price increases are accelerating, to the point that tighter policy is needed to mitigate.  However, even if it were so that we reach full employment on current trajectory (which, if EPI is right and NAIRU is closer to 4.0%, will be a ways into the future), I still think holding off on an increase is justifiable.  For one thing, wage growth has been subpar for many years – allowing it to catch up back to pre-recession trends wouldn’t be a bad idea.  This is especially true if the Fed is worried about the sustainability of the expansion.  Wage increases are necessary for increases in consumer spending (the driving force of the U.S. economy) to be sustained.  Allowing for months, if not a few years, of above-average wage & inflation growth might not be a bad thing for the sake of sustainability.

Given the existence of multiple tools to combat inflationary pressures and to prevent higher inflation rates from being too ingrained, I think the biggest drawback of this proposal of delayed tightening is that the Fed risks overshooting its employment target (meaning that unemployment is below its natural rate for an extended period of time).  Technically, this would be a violation of its dual mandate.  However, invoking the argument about this policy helping to produce long-run economic sustainability (to maintain full employment and stable prices), a temporary overshooting of the dual mandate targets might be statutorily justified.  It all depends on the timeframe the Fed chooses to create policy, which historically has been rather short (within months/a few years).  This is the difficult balancing act the Fed must consider, and which is statutorily ambiguous.

If it were to think more of the possible long-run consequences of its policies (especially as it relates to the dual mandate), an already difficult task suddenly becomes much, much more complex.  Further thinking and a cleaning of its future policy stance is in order…

TBC

The Fed Centennial: A Brief Historical Review of the World’s Most Powerful Central Bank

6 years ago to the month, the United States entered its longest and deepest post-war recession.  18 months later, in June of 2009, economic growth finally resumed.  Ever since, barring a few  quarters of “bounceback growth” in late 2009 and blips in 2011 and Q3 2013, the recovery has been extraordinarily sluggish by historical standards.  What does this have to do with the Federal Reserve’s (recent) 100th birthday?  Lots, actually.  But first, let me go all the way back to the beginning.

100 years ago to the month, the United States entered its longest and deepest experiment in centralized banking.  Congress had passed The Federal Reserve Act of 1913 to set up the Federal Reserve System, a quasi-private quasi-governmental central banking system, in response to the many financial panics that had plagued the US since its founding (especially the severe 1907 financial crisis).  It originally started out with three specific mandates: full employment, price stability, and moderate interest rates, each of which would receive particular emphasis during different periods of time.

The Fed got off to a fairly rocky start.  It failed to adequately mitigate the severe early 1920s post-WW1 recession, and exacerbated the Great Depression by attempting to fight non-existent inflation.  After the horrendous 1930s, beginning in the 1940s the Federal Reserve placed heavy emphasis on the “full employment” mandate.  This coincided with the post-war “Keynesian consensus”, in which fiscal policy was also leveraged to support the full-employment mandate.  Growth was generally robust during this time, though during the 50s growth was slower and was repeatedly interrupted by short recessions.  During the 1960s, activist monetary and fiscal policies reached their nadir, with the Fed coming under increasing political pressure to maintain full employment at all costs.  This continuous monetary expansion helped set the stage for the stagflation of the 1970s, where too much money was chasing too few goods.  Further compounding the situation was President Nixon’s removal of the dollar from the gold-standard, putting further downward pressure on the dollar.  By 1980, inflation was running in the double-digits even as unemployment now remained above the “full-employment” level of 5-6% (challenging the Phillips Curve inflation/unemployment tradeoff theory).

It was with the appointment of Paul Volcker as Fed Chairman in 1979 that the Fed’s emphasis on price stability (rather than full employment) can be observed.  Volker enacted an extremely tight monetary policy (selling government bonds to remove money from the economy, depress bond prices, push up bond yields and thus push up interest rates) that led to the double-dip recessions of 1980 and 1981-82′ (the latter being particularly severe).  After the prime rate hit 21% in 1980, it and inflation fell rapidly, as did interest rates.  Growth rebounded strongly.  From then on until the 2008 financial crisis, the Fed maintained a steadfast commitment to lower inflation (sometimes at the price of full employment).  Rates of inflation and interest steadily declined until 2008 (with intermittent spikes now and then).

Either as a cause or effect of the Fed’s actions, savings rates also trended down beginning in the 1980s, following the pattern of interest rates (which makes sense, as depositors have less incentive to save with lower interest rates).  Lower interest rates spurred consumer spending, beginning a quarter-century long consumption boom.  Balance of payments and the federal budget recorded significant deficits for the first time.  Almost all forms of debt – governmental, commercial, and household debt – began to rise as a percentage of GDP and personal income.

This unsustainable situation, as noted, would last until the late 2000s.  Just a few years earlier, after the dot-com bubble burst at the turn of the millennium, the Federal Reserve pursued what was (up until then) one of its most aggressive monetary expansions ever.  The Federal Funds target rate was repeatedly reduced until it reached around 1% until the mid-aughts.  This monetary expansion (characterized, as all monetary expansions are by massive bond buying = higher bond prices = lower bond yields = lower interest rates to hopefully spur investment, borrowing, and spending), however, coincided with the rise of surplus financial capital in other parts of the world.  A surplus of capital almost everywhere looked in vein for investment vehicles to profit from, and safe government bonds, with such low prevailing yields, would not suffice.  As a result, they turned to riskier assets such as mortgage-backed securities (MBS).  These instruments, backed by the value of actual mortgages, would yield investors dividends essentially in the form of monthly mortgage payments – a much higher rate of return than treasury bonds yielded at the time.  The demand provided by the investors of MBS’ increased the demand and funds available for mortgages, which pushed up lending and housing prices.   Of course, we now know that many of these mortgages were sub-prime and extremely risky.

CDO_-_FCIC_and_IMF_Diagram

When the Fed finally began to raise interest rates in the mid-aughts, several things occurred as a result.  Higher interest rates caused a wave of mortgage defaults and foreclosures, especially among risky borrowers.  This reduced the value of MBS’ and weakened investor demand for them, putting downward pressure on the net worth and financial positions of multiple investment banks.  This weakening of investment banks weakened demand for mortgages from mortgage lenders, who thus lent less.  This started the infamous “credit crunch”, which not only lowered mortgage lending and demand for housing (further lowering housing prices) but put pressure on all forms of borrowing.  Higher interest rates also made bonds look more attractive than risky assets, causing further pullback from investors.  Although far more complex than this explanation, this is the essence of the financial crisis that sparked the Great Recession.

The Fed responded to the crisis quickly, purchasing billions worth of “troubled” or “toxic” assets in a bid to stabilize the financial system and money supply.  The Fed funds target rate was lowered to almost zero, and the conventional monetary policy of purchasing short-term bonds was commenced.  However, even with these policies, inflation remained (and still remains) precariously low.  Thus, various “unconventional” monetary policies have also been pursued, notably “quantitative easing” (QE), in which large quantities of long-term financial & commercial assets (including long-term government bonds) are purchased with newly created money to both lower long-term interest rates and raise the quantity of money in the money supply.  As of this writing, the Fed is still purchasing about $85 billion in bonds per month as part of its QE strategy.

So, about the financial crisis and our agonizingly slow economic recovery: can the Fed ultimately be to blame?  You could argue that low interest rates pursued by the Fed ultimately pushed investors into too-risky of assets.  Of course, the Fed wasn’t the only downward pressure on interest rates since 1980 – the emergence of several developing nations has given rise to a global “savings glut” that has pushed down interest rates worldwide.  The Fed may have kept the Fed Funds rate down too long during the mid-aughts – but then again, who can really blame them, considering they were desperately trying to make sure the US didn’t enter a deflationary spiral after the dot-com bubble burst?  As for its role in our slow economic recovery, that is also unclear.  Normally after recessions, an expansionary monetary policy (and the low interest rates that come with it) spur consumer & business borrowing, spending, and investment, increasing short-term economic growth.  However, this time is different, as households and businesses are still trying to deleverage from their debt overhang (a process that requires less consumer spending and increased savings for a time).  Considering that debt deleveraging (so that debt as a percentage of GDP and household income is down to more normal levels) is essential for long-term economic growth and recovery, the downward push exerted by the Fed on interest rates could actually be retarding the process as it makes it more difficult to accumulate savings to pay off debt.  At the same time, an easing of the Fed’s ultra-loose monetary policy right now may not be a good option, either, as it may cut off all sources of growth.  Whatever the Fed’s role in the crisis and its aftermath, it is clear that the crisis has provoked a strong discussion in consideration of which part of the Fed’s mandate (if any) should be emphasized from now on.

To sum up, the Fed has had a tumultuous century.  Though it has had its monetary successes (inflation taming?), its failures weigh heavily.  Ironically, the very cause of its creation  – financial crisis – also marks the end of its first centennial.  Though there has been progress, one can’t help but feel that we’re back to square one.