Janet Yellen, not Donald Trump, is far more likely to decide whether or not we reach genuine full employment in 2017
In recent weeks, a number of stories have been written about the Trump administration’s excessively rosy projections for economic growth in coming years. And three weeks ago, Federal Reserve Board Chair Janet Yellen testified before Congress about the likely path of monetary policy over the next year. The Trump administration forecasts and Fed decisions are deeply intertwined. While the Trump administration’s precise forecasts are clearly unrealistic in the long-run, we should be clear in noting that the next couple of years could easily see a substantial pickup in economic growth. If this happens, however, we will have Janet Yellen and her colleagues at the Fed to thank, not Donald Trump.
The reason is straightforward: 2017 is the year when the Fed will finally decide whether or not to guarantee genuine full employment by giving the economy “room to run” by not raising rates aggressively. While Fed policy largely sputters when trying to spur growth with lower short-term interest rates, raising rates does reliably slow growth. So for all the chatter about the importance of Fed policy in recent years, their attempts to spur growth with low short-term rates were often futile. But once they firmly decide to start reining in growth with higher rates their policy choices will have real bite.
The metaphor used to describe the problem with using low rates to boost growth was that you can’t “push on a string”. Essentially, the Fed can lower rates to try to induce businesses and households (and even governments) to borrow and spend more, but they cannot force this spending to actually happen. If governments ignore low rates and indulge in spending austerity for ideological reasons, or if households do not respond to low rates because their housing wealth had been torpedoed and hence home refinancing is impossible, or if businesses do not take advantage of low rates to build new factories because they do not have customers for what their current factories are producing, then the Fed cannot do much about any of this.
But while the Fed has trouble spurring more rapid growth with low rates, they can reliably slow growth with higher rates; “pulling on a string” works just fine. As 2017 begins, the Fed has raised rates twice in two years, and many policymakers have declared that a more rapid pace of string-pulling should begin. The claim is that the economy has reached full employment, and that any further acceleration of spending by households, businesses, and governments (or aggregate demand) should be met by Fed rate increases to keep it from sparking inflation in wages and prices. This reasoning is presumably what lay behind the Fed decisions to raise rates at the end of 2015 and 2016.
But this reasoning is clearly premature. There is no evidence in the data that the U.S. economy is at genuine full employment. The headline unemployment rate remains significantly higher than it reached in 1999 and 2000, when we saw 4.1 percent unemployment and lower for a full two years without accelerating inflation. The share of adults between the ages of 25 and 54 with a job hasn’t even recovered to pre-Great Recession levels, which were, in turn, far below the peaks reached in the late 1990s. And, most importantly, no durable and significant acceleration of wage growth to healthy levels has happened yet. There is, in short, no reason to believe that aggregate demand is growing too fast rather than not fast enough.
The source of this too-slow aggregate demand growth is, in turn, easy to diagnose: historically austere spending by federal, state, and local governments. But there are some reasons to believe that fiscal policy may shift from restraining to boosting growth in the coming year. Trump and the Republican Congress are essentially guaranteed to pass a large and regressive tax cut in the coming year. The regressivity of this tax cut will make it extraordinarily inefficient as fiscal stimulus, with a bang-for-buck about 1/5th of equivalently sized fiscal boosts that transferred money to low- and moderate-income households and/or undertook public investments. But the sheer size of the tax cut insures that it will provide some boost to demand growth.
It should be noted that there are plenty of ways that Trump and the congressional Republicans could manage to neutralize any fiscal boost stemming from tax cuts with ill-designed cuts in spending. For example, Affordable Care Act repeal would clearly drag on demand growth because of spending cuts. Draconian cuts to Medicaid and/or non-defense discretionary spending would drag on growth as well. And while Trump has spoken kindly of infrastructure spending, the skeletal details of his infrastructure plans indicate that very little net new investment would be forthcoming from it.
But if spending cuts are skipped or deferred and fiscal policy does indeed become expansionary in 2017, this will lead to faster growth, more jobs and higher wages so long as the fiscal boost is not neutralized by the Fed raising rates to keep unemployment from falling too low. The Trump administration is clearly banking on an accommodating Fed, given recent stories about the unrealistically rapid economic growth they’re projecting in coming years.
If the Fed does decide to neutralize a fiscal boost, American workers will be worse off. The job of the Fed should be to aggressively plumb the depths of how low unemployment can go without sparking wage and price inflation. They should not start pulling back on economic support before this inflation actually occurs.
If the Fed instead decides to accommodate the fiscal boost and refrains from raising rates until wage and price inflation actually show up in the data, 2017 could be a very good year for American workers. But it will be Janet Yellen and her colleagues at the Fed who decide on this, and it will be they who would deserve the credit.