I cannot recall a moment when the gap between what markets expect the US Federal Reserve to do and what the Fed itself has forecast it will do has been as large. Markets predict that the Fed will raise rates only to 1.6 per cent by the end of 2017; the Federal Open Market Committee’s average forecast is 3.5 per cent.
Such a divergence raises the risk of volatility and poses a communications challenge for the Fed. More important, it raises the question of what should guide future policy.
Especially after Friday’s very strong employment report, there can be no doubt that cyclical conditions are normalising. The unemployment rate now is at its postwar average level, and continues to fall. Job openings are above their historic average. Other indicators such as the insured unemployment rate suggest a normal or rapidly normalising economy. All of this taken in isolation would suggest that interest rates should not remain at zero much longer.
On the other hand, the available inflation data suggest little cause for concern. The core consumer price index has averaged 1.1 per cent over the past six months; if housing costs were stripped out it would be zero. Wages actually fell in December and over the past year employment costs have risen 2.25 per cent which, in conjunction with productivity growth of only 1 per cent, suggests inflation of below 2 per cent. Perhaps most troubling: market indications suggest inflation is more likely to fall than rise.
The Fed has rightly made clear that its decisions will be data dependent. The further key point is that it should allow the flow of information on inflation rather than on real economic activity to determine its timing in adjusting interest rates. And it should not raise rates until there is clear evidence that inflation, and inflation expectations, are in danger of exceeding its 2 per cent target. Here are four important reasons why.
First, real wages for most workers have been stagnant. Median family incomes are down by 4.5 per cent over the past five years and the economy is about $1.5tn — or $20,000 for the average family of four — below pre-recession estimates of its 2015 potential.
In such circumstances efforts to reduce demand and growth require a compelling justification. Yet the idea that below normal unemployment will necessarily lead to accelerating inflation as suggested by the so called Phillips curve is very uncertain. Contrary to such predictions, inflation did not decelerate by much even a few years ago when unemployment was in the range of 10 per cent. Nor was there much evidence of accelerating inflation in the 1990s when the unemployment rate fell below 4 per cent.
Second, if inflation were to accelerate a bit this would be a good thing. It is now running and is expected to run below the Fed target. Prices are about 4 per cent below where they would have been if 2 per cent inflation had been maintained since 2007. So there is a case for some inflation above 2 per cent to catch up to the Fed’s price level target path. There may also be a case for inflation a little bit above 2 per cent for the next few years to allow real interest rates low enough to promote recovery when the next recession comes.
Third, a plane that accelerates too rapidly as it takes off may cause passengers discomfort while a plane that accelerates too slowly may crash at the end of the runway. Historical experience is that inflation accelerates only slowly so the costs of an overshoot on inflation are small and reversible with standard tightening policies. In contrast, aborting recovery and risking a further slowing of inflation is potentially catastrophic — as Japan’s experience demonstrates. So in a world where economic forecasts are highly uncertain, prudence in avoiding the largest risks counsels in favour of Fed restraint in raising rates.
Fourth, the US has never been more intertwined with the global economy. Higher interest rates and the stronger dollar they would bring would mean greater debt burdens for debtor countries, a growing US trade deficit that damages manufacturing, and growing protectionist pressures.
There is already a danger given all the problems in Europe, Japan and emerging markets that safe haven flows will drive the dollar up to the point where the US economy could be significantly slowed. Raising rates without evidence of rising inflation could dramatically increase real rates and exacerbate these risks.
None of this is to say that rates should never be raised or that inflation indicators might not justify a rate increase before long. It is to say that the Fed could inject much needed confidence in the economy today and minimise future risks by announcing and following a strategy of not raising rates until it sees the whites of inflation’s eyes.
The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary
Letter in response to this column: