Patience is a virtue when it comes to U.S. interest rates

The last time the U.S. Federal Reserve raised short-term interest rates was in early July 2006. To say a few things about the economy have changed since then is quite an understatement. Nine years later, the Federal Open Markets Committee is now deciding when to start the process of raising rates once again. After nearly a decade since the last rate increase, years of extraordinary monetary policy, and evidence that the current economic recovery has some forward momentum, the desire to return to normalcy is understandable. Yet this impulse should be ignored.

The Fed has announced, in line with its mandate to foster price stability, that it targets a rate of 2 percent annual inflation “over the medium term.” Essentially, the Fed is saying that while inflation might not always be exactly 2 percent, the central bank tries to hit that mark over the course over a number of years of a business cycle. Yet the Fed’s recent track record doesn’t seem to match this target. As Ben Leubsdorf shows at The Wall Street Journal, inflation over the past three years hasn’t once reached 2 percent, according to the Fed’s preferred measure.

Perhaps an argument could be made that the current recovery is self-sustaining enough to eventually spark higher inflation. But so far this year, core inflation, which ignores the volatile prices of food and energy–and is a good predictor of future inflation–appears to be on a downward trend. If the target were truly 2 percent, then we’d expect inflation to be over 2 percent at times. Yet that hasn’t happened since the middle of 2012. Raising rates now would be indicative of a 2 percent ceiling rather than a 2 percent target.

But what about wage growth? The growth in average hourly earnings measured on a year-to-year basis has yet to accelerate, even though that measure on monthly basis might be increasing slightly. Some observers point to the Employment Cost Index, which includes other forms of labor compensation. But while there are signs of acceleration there, the level of compensation growth is below the level we’d expect—bearing in mind a 2-percent inflation target and slow productivity growth.

But let’s say wage growth does accelerate significantly in the coming months before interest rates are raised. Given the fact that monetary policy has consistently failed to promote full employment leading to slow wage growth, letting wage growth run a bit hot might be exactly what’s called for. Recent research from Federal Reserve economists argues that wage growth won’t necessarily pass through to overall inflation like it did in the past.

The 0.2 percent contraction of U.S. gross domestic product in the first quarter is troubling, too, but looking at an alternate measure of output growth– gross domestic income–shows growth of 1.9 percent. Given the rate of employment growth during the same time period, it seems more likely that underlying growth is probably closer to this GDI estimate.

But what the GDP report did highlight was the extent to which the strength of the dollar is depressing economic growth. Jared Bernstein at the Center for Budget and Policy Priorities points out this trend for the last two quarters. The greenback’s appreciation has been fueled by expectations of a Federal Open Market Committee decision to hike interest rates as the European Central Bank eases its monetary policy. So perhaps hesitation on behalf of the Fed might temper this trend moving forward.

Despite all this evidence in favor of waiting to raise U.S. interest rates, news reports indicate that members of the FOMC are moving toward an increase this year. So if the committee is intent on starting a path to normalization, then let’s hope the path is a slowly rising one. A slow path upward would be the easiest path forward if at least some rate increases have to happen.

June 29, 2015


Monetary Policy

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