Department of “Huh?!”: Martin Feldstein and the Interest Rate Path Edition

It is the absence of any recognition of the asymmetric power of the Federal Reserve’s policy tools that leaves me most puzzled by the extremely-sharp Marty Feldstein this morning:

Martin Feldstein: The Fed Needs to Step Up Its Pace of Rate Increases: “The Federal Reserve[‘s]… projected path for increasing the short-term federal-funds rate over the next few years is dangerously slow….

…Only in 2017 would the real fed-funds rate even exceed 1%…. The Fed is… projecting that its policies will cause unemployment to decline to 5% by the end of 2015 and even lower in the next two years. Historical experience suggests that means inflation would eventually increase year after year….

Recent academic research… implies that what matters for accelerating inflation is not overall unemployment but unemployment among those who have been out of work for less than six months. For this group of short-term unemployed, the inflation threshold is estimated to be between 4% and 4.5%. The latest count by the Bureau of Labor Statistics puts the unemployment rate for that group at less than 3.9%. This could mean inflation will soon begin to rise year after year without any further decline in overall unemployment….

Finally there is the important issue of financial stability…. The process of reaching for yield has increased bond prices, narrowed credit spreads, and pushed the stock market’s price-earnings ratio to 19, 25% above its historic average…. Investors believe they have complete liquidity because they can redeem their investments at any time. But if many of them tried to do so, the bond funds and ETFs would have to sell the underlying corporate bonds. It is not clear who the buyers would be…. The Fed’s current slow path to more normal interest rates is not justified by its employment and inflation mandates…

Let’s review the videotape. The Federal Reserve believes that the proper longer-run mid- and late-expansion value for the federal funds rate is 3.75%. It expects to be within half a percentage point of that rate in twenty months–by the end of 2017:

US Equity ETFs Market Realist

Core inflation has not been at its 2% per year rate target for more than a month in the past three years:

Graph Consumer Price Index for All Urban Consumers All Items Less Food Energy FRED St Louis Fed

We thus need a period in which unemployment is beneath the NAIRU in order to even return inflation to its target. But there is no sign as of yet in wage growth that it is:

Graph Average Hourly Earnings of Production and Nonsupervisory Employees Total Private FRED St Louis Fed

Janet Yellen projects and wishes for unemployment to fall further, and is confident that when it falls further wage growth will reemerge and inflation climb back to its target. She is confident that if inflation climbs above its target she can quickly and substantially raise interest rates to bring inflation back to target. But she is not at all confident that if she raises interest rates as fast as Feldstein wishes and the economy weakens that she will then be able to strengthen it.

Yet there is no acknowledgement of this asymmetry anywhere in Feldstein’s piece.

March 31, 2015

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