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Staying its hand
A strengthening economy creates a dilemma for the central bank
Jul 30th 2016 | WASHINGTON, DC | From the print edition
BY MOST measures, America’s economy is flourishing. Unemployment is only 4.9%. From April to June payrolls swelled by a healthy 147,000 per month, on average. Consumer confidence is strong and sales of new homes are higher than at any time since 2008. Financial markets have mostly shaken off their early-year worries about Chinese growth and their summer blues over Brexit. Second-quarter growth, due to be revealed after The Economist went to press, was expected to rebound after an underwhelming start to 2016 (mirroring last year). Yet on July 27th, the Federal Reserve opted to hold interest rates in the target range of 0.25%-0.5% for the fifth consecutive meeting. What explains the central bank’s hesitation?
One answer is that inflation, according to the measure the Fed targets, is just 0.9%, well below the central bank’s 2% goal. But Janet Yellen, the head of the Fed, has long argued that price rises will pick up as the effect of cheap oil and a strong dollar dissipates. Core inflation, which excludes food and energy prices (and usually prefigures the headline measure), is 1.6%. And competition for workers is pushing up wages. The median annual pay rise is 3.6%, according to the Atlanta Fed—almost the same as it was in July 2006. That suggests slack in the economy is disappearing (see chart).
A more subtle problem also lies behind the Fed’s inertia: it is hard to tell how loose monetary policy really is. That depends on the “natural” interest rate, the level which would, in theory, cause inflation to neither rise nor fall. If rates are much lower than this, then the Fed is providing foot-to-the-floor stimulus. But if they are only slightly below it, the Fed is merely giving the economy a gentle push.
The latter looks more likely. A recent estimate by the San Francisco Fed put the natural rate in real terms (subtracting inflation) at 0.4%. If the Fed were hitting its 2% inflation target, the natural nominal rate would be 2.4%. With inflation at 0.9%, today’s rates look only modestly stimulatory.
Several factors are holding down the natural rate. One is weak productivity growth. In the previous economic expansion, in the 2000s, productivity growth averaged 2.5% a year. Since the financial crisis, it has averaged just 0.9%. Another cause is an ageing population, which, by reducing the capacity of the economy to produce, deters investment. Economic pessimists say these forces and others are causing a “secular stagnation”.
The Fed’s rate-setters are becoming more open to this possibility, says David Mericle of Goldman Sachs, a bank, having previously preferred to describe the drags on growth merely as “headwinds”. Since December, their median estimate of where rates will settle in the long run has fallen from 3.5% to 3%. James Bullard, the president of the St Louis Fed, recently abandoned a hawkish position to argue that the economy is now in a low-rate “regime” which is likely to persist. Markets, too, expect low rates to continue (a ten-year Treasury bond yields just 1.5%).
The Fed did say, in its post-meeting statement, that short-term risks have “diminished”. The strength of the consumer means there is a chance of a rate rise this year; markets put it at about 40%. But had the Fed a clearer view of the long-term picture, rates would probably be higher by now. When visibility improves, some abrupt steering may be necessary.
From the print edition: Finance and economics
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