Fed should keep rates steady to keep targets from turning into ceilings
All eyes will be on the Federal Open Market Committee (FOMC) today as they decide whether or not to follow up December’s interest rate hike (the first since 2006) with another. A consensus seems to be firming that they will hold pat in March and instead are likely to raise in June. Holding still and not raising rates is likely the right decision for two reasons: it will help reverse past damage left over from the Great Recession and will also make the job of future FOMCs easier because it will build credibility.
Both of these benefits stem from the Fed’s inability to keep wage and price inflation from running consistently below healthy targets in recent years. The Fed’s dual mandate is to maximize job-growth and push down unemployment while maintaining stability in inflation. The Fed has adopted an inflation target of 2 percent for “core” prices (ie, excluding food and energy) in the personal consumption expenditures (PCE) deflator. Yet the PCE core deflator has seen annualized growth of less than 2 percent for years now, and there’s no sign yet in the data that it is even moving durably closer to this target.
The stubbornness of the PCE data, which is clearly the target that the Fed has specified in the past, has led many to highlight recent data in another core price measure—the consumer price index (CPI) excluding food and energy. The core CPI showed 12-month growth a bit above 2 percent in January and February, but the CPI always rises a bit faster than the PCE, and so the Fed’s price target expressed in CPI terms is closer to 2.5 percent. Further, it’s important to realize that the faster growth of core CPI prices is overwhelmingly due to relatively rapid growth in shelter costs (which enter the CPI with a much larger weight than the PCE). As Dean Baker of CEPR notes,if the cost of shelter is rising due to deficient supply of housing relative to demand, then interest rate increases which slow residential construction investment would seem a perverse strategy for dealing with this.
An overall price target of 2 percent implies a target for nominal wage growth of at least 3-3.5 percent. More precisely, the growth rate for nominal wages consistent with the Fed’s inflation target is simply that target (2 percent) plus the trend growth rate of economy-wide potential productivity (assume it’s somewhere between 1 and 1.5 percent). The logic of this wage target is simple – because productivity growth means that more output can be produced in a given hour of work, it reduces the cost of output per unit, holding down inflation. So, if wages rise by 3.5 percent but productivity rises by 1.5 percent, than labor costs per unit of output only push up prices by the Fed’s preferred 2 percent target. Just like overall price inflation, wage inflation has been well beneath the healthy target of 3.5 percent for years now.
The rebuttal to claims that the Fed should not begin slowing the economy until the wage and price inflation targets are reached is that because their actions affect the economy with a lag, and because economic growth has momentum, they need to act before the target is reached to avoid a sharp overshooting. This seems deeply unconvincing. For one, there is little momentum in growth recently—growth was 2.4 percent year-on-year in both 2014 and 2015, but fell to 1 percent (annualized) growth in the last three months of 2015. Further, while in some recent months at the end of 2015 there seemed to be some uptick in wage-growth, last month’s data showed a sharp retreat in wage growth, with nominal wages outright falling in February. And the closely watched employment cost index (ECI) data showed slowing hourly compensation growth in the last three months of 2015.
Further, if the Fed tightens too far before economic momentum has pushed wage and price inflation towards their healthy targets they will risk transforming these targets from averages into hard ceilings. This would be a large, unforced policy mistake. Having wage and price inflation run so slowly in recent years has done real damage. Slowing inflation has made it harder to erode household debt overhangs—mortgages and other debts have become more onerous in inflation-adjusted terms if they were incurred when future inflation was expected to be faster than it turned out to be. Wage inflation running well below target has translated directly into historic lows in the share of national income accounted for by workers’ pay rather than returns to capital owners. Enforcing wage and price inflation targets as hard ceilings means that the excess burden of debt and the historic lows of the labor share of income would be solidified as a “new normal.” There’s no need for that—the past years’ undershooting of wage and price inflation should be matched by an equivalent overshoot as the decent job growth in recent years continues to keep this damage from congealing into permanence.
Besides the obvious benefits of eroding nominal debt for households and clawing back some of the labor share of income lost during the early parts of the recovery, reinforcing wage and price targets as averages rather than ceilings is the better policy for building central bank credibility. A recurring theme in the theoretical literature on the zero lower bound (ZLB) problem is that monetary policy is much more effective in pulling an economy out of recession when short-term rates are zero if the central bank can credibly commit to having inflation exceed the long-run target for a spell during the recovery. Since this is the first time the United States has faced a recession at the ZLB, this credibility is subject to some question. But if the Fed does not follow undershooting on inflation for years with a period of overshooting, this credibility for the next recessionary episode at zero interest rates won’t just be in question, it will be shot.
Holding off this week would be the right move, both for avoiding an unnecessarily austere “new normal”, and for giving future Feds valuable credibility in fighting the next ZLB recession.