Sunday, September 20, 2015

4 reasons the Fed made the right decision (kind of, for now)

As you likely know, the Federal Reserve's Federal Open Market Committee (FOMC) made the decision on September 17 to keep the federal fund target rate unchanged at 0-0.25%. Personally, I believe this was a fairly good idea, but that the FOMC should move more aggressively to stimulate the U.S. economy.

What are the Fed's goals? There are two explicit goals: (1) maximum employment and (2) price stability. What does the Fed think is happening? From the press release:
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term.[1]
 I will get back to the view of the Fed and how my view is different later. First, I'll give you 4 reasons that the Fed made the right decision not to increase the Target Federal Funds Rate.

#1 - Inflation is lower than the Fed's 2% target rate

The Federal Reserve has a definition of price stability by which they mean that prices should rise at a rate of 2% per year. In June, the FOMC estimated that the rate of inflation would rise to 2% by 2017. Now that it is September, the FOMC doesn't believe this will happen until 2018. Consider the following graph of recent inflation by different measures:

Source: FRED

Many economists give the most credence to measures of inflation which exclude food and energy as predictors of future inflation. From the graph you can tell that these rates have been consistently below 2% since early 2013, and the FOMC expects this to remain true until 2018. Given that inflation is expected to remain low, this argues for relatively loose monetary policy.

#2 - Our economy could produce much more

The U.S. Congressional Budget Office puts together estimates of potential output based upon their economic model. Based on their model, the most recent quarter for which output data is available, the U.S. economy is operating 3% lower than would be consistent with stable on-target inflation.

Source: FRED

According to the graph of the output gap, the U.S. economy was at its productive capacity in 2006-2007, before the beginning of the "Great Depression 2.0."[2] If there is considerable slack in the economy, as remains the case today, it could be a big mistake to raise interest rates.

#3 - Workers' wages are not rising rapidly

Another measure that should matter for deciding whether or not rates should rise is the employment situation. Usually, economists would look at where unemployment stands relative to the level that is consistent with stable inflation. The graph below shows two things: (1) the level of unemployment minus the estimated natural rate of unemployment (so zero is full employment) and (2) the year over year growth rates for non-supervisory hourly wages.

Source: FRED

The unemployment figure shows that, by that figure, the unemployment rate is almost at a full employment level.[3] My opinion is that if "full employment" is reached, but other factors don't warrant a change in the target rate, it makes more sense to allow further employment growth rather than choke it off. After all, no model is certain and if lower unemployment actually is consistent with stable inflation, why not allow more people to have jobs?

According to many models, there is a potential that inflation would rise because wages rise. This is commonly referred to as a "cost push" inflation. According to a 2013 Working Paper by Robert Shackleton, productivity has grown about 1.2-1.5% from 1950-2010. Given this and the inflation target of 2%, wages could grow at 3.2-3.5% and still be consistent with a 2% growth in wages per productivity-adjusted hours worked. The chart indicates that wage growth has been below this level since roughly the end of the most recent recession (indicated by the light bar just before 2010). That is a further reason that keeping the target federal funds rate very low remains a good idea.

#4 - Escaping near-zero interest rates

A further issue with all this is that the effective federal funds rate has been near zero for over 6 years now:

Source: FRED

If we are going to escape the near-zero interest rates, inflation needs to at least get back to target before the interest rate is raised. In my opinion, the interest rate target needs to have an upper target threshold of maybe 2.5% or 3%. Until that target threshold is met, the policy should remain loose.

This brings me to my other main point. I believe that the indicators I have presented point toward not only keeping the interest rate at target, but expanding another form of quantitative easing, if for no other reason than to demonstrate to markets the commitment of the Fed to bringing economic activity back to full employment. Considering the near-zero interest rates, the inflation rate is too low and, according to the FOMC, they expect it to remain below 2% until 2018. Real GDP is still far from its previous full-employment trend. Wages are not growing in a manner consistent with 2% inflation and 1.2-1.5% productivity growth. Further, even though unemployment is nearing an estimate of its long-term full employment level, without any of these other metrics looking more promising, there is every reason to think that the full employment level is lower than previously believed.

I agree that the Fed made the right decision to not raise the federal funds target rate, but more should be done to ensure a quick return to the United States' economic potential.

[2] I consider the often-used term "Great Recession" to be a misnomer, since the U.S. economy has remained depressed even years afterward. In that spirit, it out to be called something like "Great Depression 2.0."
[3] The long-term natural rate is from the CBO.

1 comment:

  1. I agree with your thoughtful, well-presented analysis.