The Federal Reserve can’t stop supporting economic growth now

The Federal Reserve’s policymaking committee, the Federal Open Market Committee, will finish its two-day meeting today and release a statement after the meeting. That statement, the FOMC members’ economic projections, and Fed Chair Janet Yellen’s press conference later in the day will all be carefully examined to divine the Fed’s future policy moves.

The expectation is that the FOMC will continue its “taper” of quantitative easing—Fed speak for large purchases of long-term U.S. government bonds and mortgage-backed securities to inject cash into the economy—and may even signal when future interest rates will increase. In other words, the Fed is slowly pulling back from its efforts to boost the economy. Proponents of this pullback have cited concerns about possible new bubbles upsetting financial stability or the improving labor market. But the counterargument is that increasingly tight monetary policy would harm an already scarred labor market, slow economic growth, and increase economic inequality.

The current fad among central bankers is macroprudential policy, the idea that central banks can pop bubbles by reducing credit in the economy or even increasing interest rates. Yesterday Mark Carney, the Governor of the Bank of England, announced that the central bank “will not hesitate” to cool down an apparent housing bubble. At the Federal Reserve, former Fed Governor and current Harvard University economist Jeremy Stein—the intellectual leader of those concerned about financial stability—has raised concerns in a number of speeches that quantitative easing could increase financial instability. He argues that reducing the pace of bond purchases by the Fed and then ending it entirely would increase stability.

But a look at the Fed’s earlier attempts at quantitative easing indicates the relationship between QE and financial stability isn’t so clear cut. Economist Gabriel Chodrow-Reich of Harvard University looked at the effects of unconventional monetary policy and found there is no trade-off between expansionary monetary policy and financial stability. The International Monetary Fund (via Mike Konczal) has also looked into this question and found evidence that monetary policy affects financial stability in a variety of ways but says it’s not certain which effect would be the strongest.

So the total effect of tightening policy is uncertain.

Even if monetary policy could easily pop bubbles, the Fed is mandated to promote maximum employment. With our current labor market, employment is anything but maximum. The unemployment rate has dropped considerably from its high of 10 percent to its current rate of 6.3 percent. But this decrease is largely due to workers dropping out of the labor force. The share of Americans with a job, about 59 percent, is still 4 percentage points below its pre-recession level. So will these discouraged workers, particularly the long-term unemployed, ever rejoin the labor market? Should we assume they are forever lost?

One way to answer these questions is to look at the growth in wages. If wage inflation is high or rising, then the labor market is tight and these discouraged workers are locked out. Alan Kreuger, the Princeton University economist and former Chair of President Obama’s Council of Economic Advisers, has done research supporting this view. On the other hand, if wage inflation is low, then the labor market has considerable slack. And therefore, the Fed can continue to pursue expansionary monetary policy. Chair Yellen has taken this view in opposition to Krueger, seeing the long-term unemployed as once-and-future members of the labor force.

The graph below shows the year-on-year growth in nominal wages. During the period of declining unemployment rates and workers dropping out of the labor force, wage inflation has been muted. The case for slack looks strong. (See Figure 1.)

Figure 1

The consequences of tightening policy too soon may be severe. Locking discouraged workers out of the labor market would reduce long-run economic growth and cause huge personal harms to these workers. Research also finds that tight monetary policy also increases income and consumption inequality.

The Fed, along with other policymakers, have stopped the leaking holes of our economy. But there’s still quite a bit of water left in the boat. Keeping the water on board will not only damage the cargo, but keep the boat from going full speed. For lack of a better term, the Fed needs to go back to bailing out the boat or risk the consequences for the real economy.