Later this afternoon, the Federal Reserve will almost certainly announce that it has again decided to raise the interest rate it controls by a quarter of a percent, targeting a “Fed funds rate” between 1.75 and 2 percent. The central bank tends to telegraph these increases and the markets are placing a 96 percent likelihood that it follows through.
That’s what the Fed will do. But is it what it should do?
On one level, the answer is: “Of course.” That is, after convincing everyone the rate hike is coming, to not raise would send a shocking, negative message that the Fed thinks the economy is weaker than we thought they think it is.
But on a deeper level, is the Fed’s “normalization campaign” — slowly raising its benchmark interest rate to reduce the possibility of economic overheating — the right policy for the moment?
The first step to answering the question is to see whether the Fed is meeting its “dual mandate”: maximum employment at steady prices. But that’s way easier to say than to measure. First, that framework assumes a negative correlation between inflation and economic slack. But for years now, as the job market has tightened, inflation has barely moved. That diminished correlation makes both the Fed’s job and evaluating its job far more of a guessing game.
Price growth has started to tick up a bit of late, leading some to suspect that eventually the old negative correlation will reawaken. But inflation remains remarkably low, stable and unresponsive to low unemployment (note: the Fed’s favored inflation gauge leaves out volatile food and gas prices).
But if unemployment is very low (last month’s rate of 3.75 percent was the lowest rate since 1969) and price growth is also low and stable, isn’t the Fed meeting its mandate? And if so, why tap the growth brakes at all with a rate hike? Why not just kick back and allow the benefits of growth to reach those who’ve been left out of the economic expansion? After all, much like prices, wage growth has been subdued, rising less quickly than we’d expect given such low unemployment. Just on Tuesday, a government report showed that over the past year, real hourly wages haven’t gone up at all.
The Fed’s governors give two basic rationales for raising: “staying ahead of the curve,” and to get back to normal.
Because their rate hikes operate with a lag, the hitting-the-brake analogy isn’t quite accurate. If Fed policy were really like driving, you’d have to hit the brake a few blocks before you wanted to start slowing down. Prices and wages tend to be “sticky,” meaning they change slowly in response to stimuli (maybe 6 to 18 months), and even though other interest rates quickly change with the Fed rate, their impact takes a while to ripple through the economy. Mortgage rates are influenced by Fed rate changes, but most home loans are fixed and not immediately affected by the change (low Fed rates can and do pump up refis, but not right away). Bank rates on deposits have been shown to have a particularly sticky response to Fed rate hikes.
As far as getting back to normal, though today’s is the seventh rate hike since the Fed began raising rates in late 2015, before that the Fed funds rate had been about zero for an unprecedented six years (2009-15). Consider this: Historically, when the unemployment rate has been between 3.5 and 4 percent, the Fed funds rate has averaged 5 percent, three points higher than the top end of the new 2 percent target they’re expected to set today.
Such historical comparisons, however, provide weak guidelines, because the economy has changed in portentous ways. Inflationary pressures are much dampened today relative to the 1960s and 1970s. Workers have far less bargaining clout to push for higher wages that could bleed through to prices. The growth of global supply chains has significantly boosted the supply of goods, staving off price pressures. Given the dollar’s status as the world’s premier reserve currency, global finance pumps up capital inflows, putting downward pressure on interest rates and strengthening the dollar, which in turn lowers import prices and thus, inflation.
In fact, these changing dynamics give rise to the danger of Fed officials fighting the last war, thereby raising rates too quickly for fear of a 1970s inflationary monster that has long been banished from our shores.
If all of that nuance (or, if you prefer, hemming and hawing) just makes you desperate for a one-handed economist (so she can’t invoke “the other hand”), I feel your pain and I’ll give you my unequivocal 25 basis points two cents in a moment. But one reason I laid out all the above is to point out that making these interest rate calls is no simple matter these days, or at least it shouldn’t be. If a Fed governor says that continuous rate hikes are the only obvious course, he or she is not being thoughtful enough.
Thus far, I think the Fed’s doing a good job managing monetary policy in the recovery. Former Fed chair Janet L. Yellen and current Chair Jerome H. Powell have resisted hawkish calls to raise rates too quickly and both have been sensitive to the part of their job that I think is most important right now: sustaining the recovery so its benefits might reach more people. Today’s small hike is consistent with that path, steering a course between their desire to both normalize rates and stay ahead of future price pressures, while not shutting down the momentum toward even lower unemployment.
In closing, allow me to underscore the point that the Fed remains one of the few functional institutions left in this town. This is fully a function of their political independence and a reminder of how important it is to maintain that feature.