Yellen Tightens Long-Run Focus

James Bryan, Hamilton College

 

Following the collapse of the American Economy during the Great Recession, the Federal Reserve took aggressive action to stabilize markets and add some much-needed liquidity to the frozen banking system. In addition to using conventional monetary policy – cutting the fed funds rate to effectively zero by the end of 2008 – the Federal Reserve implemented unconventional and unprecedented asset purchases starting with $600 billion in agency debt and mortgage backed securities. This bold stimulus, along with accommodating and timely fiscal policy, helped change the direction of the American economy and set the country on the road to recovery. Since then, the Fed has handled the recovery admirably by seemingly leaving in place the proper amount of accommodative policy long enough for the recovery to continue without taking unnecessary risks.

 

The Road to Recovery

Once it was clear the country was on the road to recovery, the Fed had to pursue the normalization of monetary policy (unwinding their balance sheet and bringing the interest rate back to expected long-term levels) in a way that would neither impede the recovery nor cause unwanted inflation. The first step on this long journey was the announcement that they would begin tapering their monthly asset purchases in December of 2013. In the following months as quantitative easing began to wind down, the Fed properly observed a resilience in the steady economic recovery (average job growth in 2014 was 246,000 jobs per month) and eventually ceased all asset purchases in October of 2014. Realizing that the recovery was still fragile and there was fear in the market about the effects of further tightening monetary policy, the Federal Open Market Committee implemented reassuring language that the fed funds rate would not be raised for a “considerable time”. After allowing the markets to continue to gain strength, the central bank eventually transitioned into the current phase of slowly raising the fed funds rate back to expected long-term levels, with the first rate hike occurring in December of 2015.

The Results

The data following the Fed’s actions should speak for itself: the recovery has been consistent and enduring, albeit unspectacular, and inflation has remained just under the long-term target of 2% for years.

 

Employment

Since the beginning of 2010 we have observed a record breaking consistency in private sector job growth and a corresponding steady decline in the unemployment rate. The result is an economy that is fast approaching full employment, with the current rate at 4.4%. We should consider that the labor force participation rate has steadily declined due to a combination of an aging workforce and a subset of citizens who are no longer actively looking for work. This implies that the current unemployment rate may be somewhat understated, but we should not forget that the U6 unemployment rate, which accounts for discouraged workers and those who are working part-time for economic reasons, has followed a similar path of steady decline.

Many critics of the Federal Reserve and the administration that served during the recovery argue that the return to full employment was slowed by the lack of explosive GDP growth. These criticisms are largely unfair and fail to take into account macroeconomic conditions that would have made a speedy recovery either irresponsible or downright impossible. First, recessions that stem from the financial sector tend to have slower recoveries, as tepid lenders instill rigid restrictions on loaning money, thus freezing capital and removing liquidity. Second, during the recovery many of America’s main trading partners were going through similar economic difficulties, preventing an ancillary decline in the value of the American dollar that could have provided foreign stimulus. Lastly, the American workforce is aging. As the baby boomers retire and the labor force participation rate naturally declines, it is unrealistic for the economy to continue to grow at its previous rate. Despite all of these headwinds, the combination of monetary and fiscal policy was still able to stably pull the American economy out of the worst recession in 80 years.

 

Inflation

On the other side, inflation has remained remarkably constant despite the improving economic situation and turbulent energy prices. Since the Great Recession, the Personal Consumption Expenditure Index (the Fed’s preferred measure of inflation) has stayed steadily just under the two percent inflation target. This appears to defy the classic Phillips curve – the tradeoff between employment and inflation – and is a sign that the Fed has admirably achieved their goal of reaching full employment while keeping inflation stable. Regardless of their apparent success in steadily improving the employment outlook without causing price increases, the Fed has not gone without criticism from the left and the right. The former tends to argue they should have left accommodative measures in place for longer periods of time, and the latter feels the Fed’s actions have artificially propped up the American economy at the expense of long-term stability. These voices are seemingly getting louder and the Fed will have to continue to navigate a hostile climate in their difficult decisions ahead.

 

 

What Next

Despite the success of American monetary policy since the Great Recession, there is still a difficult balancing act ahead. The Fed faces mounting pressure from business leaders and the progressive left to keep interest rates low for more time, especially given that price levels seem under control. This policy would be short-sighted, and over-prioritizes short-term economic gain at the expense of long-term stability. Although inflation is not currently a threat, and probably won’t be in the short and even medium term, the Fed should consider a variety of longer term threats that justify staying on their current path of gradual interest rate hikes.

First, if the current circumstances hold, inflation will eventually become an issue due to diminishing slack in the labor market. The unemployment rate has dropped to levels that many economists considered below full employment during the recession. As a result, we will slowly start to seeing wages begin to rise, and they already have, as 2015 saw the fastest wage growth for the middle class and working poor since the statistic began being tracked. Employers will continue to pay more for qualified workers, which will increase wages and aggregate demand as a whole. Inflation is a lagging indicator, thus higher wages won’t immediately result in higher prices, but monetary policy is slow to take effect and by the time inflation is already above two percent and rising, the appropriate time for tighter policy will have passed. Additionally, energy prices are relatively low by historical standards, and an unexpected spike could raise production costs for producers that could have a swift and substantial upward pressure on consumer prices.

When deciding whether to continue forward with gradual rate hikes, the Fed needs to simultaneously consider that the economy has been incredibly resilient to small changes in monetary policy and any rate increases now could give the Fed flexibility in a potential future recession. The resilience and consistency in the graphs above, despite the various changes in monetary policy during the recovery, suggest there will likely be only a marginal adverse effect from slowly raising the fed funds rate. Additionally, incremental increases will give the central bank extra ammunition to combat potential future recessions. In a hypothetical future economic downturn, having the fed funds rate at 3%, rather than 1%, gives the Federal Open Market Committee more room to cut interest rates in a drastic fashion, which could prove critical in blunting a future external shock or halting a cyclical downturn.

I want to make clear that I am not advocating for anything drastic here. The Fed should absolutely remain cautious and data driven in the coming months and even years. They should not hike rates aggressively and should put off eventual tightening if soft economic data becomes the norm. However, the notion that the fed funds rate should stay at its current level simply because inflation is not imminently threatening is short-sighted. Inflation will eventually come, energy prices may rebound, and a gradual rate hike will not have a substantially adverse effect on the resilient American economy. Although it is tempting to leave accommodative policy in place, the long-run side-effects could prove destabilizing and harmful to long term economic health.

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