March 16, 2016
The Federal Reserve Board’s Open Market Committee (FOMC) voted not to raise interest rates at today’s meeting, but their statement indicates that they are still very much looking toward further rate hikes this year. It is difficult to see reason for this urgency.
The justification for raising rates is to prevent inflation from getting out of control, but inflation has been running well below the Fed’s 2.0 percent target for years. Furthermore, since the 2.0 percent target is an average inflation rate, the Fed should be prepared to tolerate several years in which the inflation rate is somewhat above 2.0 percent. In fact, since wages badly lagged productivity growth during the recession, the Fed should be prepared to allow for a period in which real wage growth slightly outpaces productivity growth in order to restore the pre-recession split between labor and capital. If preemptive steps are taken by the Fed in the near future that prevent workers from regaining their share of national income, that implies the use of the Fed’s power to make permanent the shift from wages to profits that took place in the recession.
The most recent data provide much more reason for concern that the economy is slowing more than inflation is accelerating. Nominal retail sales declined in both January and February. Construction is at best mixed with residential construction being close to flat in recent months and private non-residential construction falling slightly in recent months. The continuing rise in the trade deficit is a further drag on growth. In the current environment, it is difficult to argue that the economy is growing too rapidly and that the Fed must slow growth.
On the inflation side, there is little prospect that the core inflation rate will even reach 2.0 percent. Over the last year, the core PCE deflator increased by just 1.7 percent.. The core CPI is showing a somewhat higher rate of inflation, but this is being driven by rising rents. The core CPI, excluding the shelter component, has risen by just 1.6 percent over the last year. Insofar as rising housing costs are viewed as a source of inflation pressure, the Fed will only worsen the problem by raising interest rates. The goal of policy in this case should be to increase the supply of housing to put downward pressure on prices. Higher interest rates will go in the opposite direction by discouraging construction.
In addition to the lack of any noticeable price inflation, there is no clear upward trend in wage growth. In fact, the most recent data suggest a modest slowing of wage growth. Taking the average of the last three months compared with the prior three months, the average hourly wage increased at an annual rate of just 2.0 percent, down from a 2.2 percent rate of increase over the last year. The Employment Cost Index (ECI) shows a similar story, with the index rising by just 2.0 percent over the last 12 months compared. The ECI had risen by 2.6 percent in the 12 months from March of 2014 to March of 2015, indicating that wage growth is slowing rather than accelerating.
Furthermore, there are many other measures indicating that there continues to be considerable slack in the labor market despite the relatively low unemployment. There are no plausible explanations for the sharp drop in the employment rate of prime-age workers at all education levels from pre-recession levels, apart from the weakness of the labor market. The amount of involuntary part-time employment continues to be unusually high in spite of recent declines. And the duration measures of unemployment spells and the share of unemployment due to voluntary quits are both much closer to recession levels than business cycle peaks.
In short, there seems little justification for the Fed’s desire to raise interest rates. With no evidence of inflation posing a problem any time soon, the Fed should be looking to boost the economy rather than slow it.
