Fed likely to stand pat today on interest rates: Right call, but important to understand why
The Federal Reserve is widely expected to keep the interest rates it controls unchanged today, after raising rates at its last meeting of the Federal Open Market Committee. This decision would be welcome. It’s important, however, to not just applaud the decision, but to explain why it was the right one: Much of the commentary in the run-up to today’s meeting stresses “uncertainty” as the reason for the Fed’s expected decision. This view implicitly takes the Fed’s main job as calming jittery financial markets.
In reality, the most compelling reason for the Fed to stand pat and give the economy “room to run” (in Chair Yellen’s phrase) is not found in financial markets, but in labor markets. In these labor markets there are no signs at all that wage growth is accelerating at a rate that would spur overall price inflation over the Fed’s 2 percent target. Some measures of wage growth have seen some good pick-up in recent months, but even these remain below what wage growth should be in a healthy economy. Meanwhile, some recent measures of wage growth show continued flatness, and are putting a substantial downward drag on overall price growth. Last week’s data on gross domestic product showed that on the Fed’s key price barometers—“core” prices for consumption goods (excluding volatile food and energy)—saw inflation decelerate rapidly, to 1.3 percent over the last three months.
This is inflation far below the Fed’s stated 2 percent long-run target. Consistently missing the inflation target from below is actually a more-damaging mistake than allowing inflation to exceed the target for a short spell. And until there are signs that labor market tightening has led to genuine full employment that is generating nominal wage growth of 3.5 percent consistently, it is not time to raise interest rates.
There will be a temptation by some to argue that the Fed should be raising rates sooner rather than later even in the absence of inflationary pressures in anticipation of large fiscal changes in the coming year. Given the unified Republican control of the presidency and the Congress, and given Republican policymakers’ endorsement of large tax cuts, the argument runs that the economy will soon receive a substantial fiscal boost and that this will lead to overheating unless the Fed gets ahead of the curve and begins monetary policy tightening. However, this is asking far too much from the Fed in responding to hypothetical political events rather than concrete economic ones. Further, the same Republican policymakers who consistently argue for large tax cuts often argue for steep spending cuts to finance them. It’s true that their preference intensity on tax cuts seems larger, but a tax cut paired with large spending cuts would actually lead to substantial fiscal drag on the economy in coming years. If the Fed had, in the meantime, begun raising rates, this would leave the economy in a terrible place.
The Fed is likely to make the right decision today, but let’s be clear about why: because the economy still has not achieved genuine full employment.