The Federal Reserve isn’t often as politicized as it is today. The last two years have seen the near-nomination of two know-nothings, Stephen Moore and Herman Cain, to the Federal Open Market Committee, along with the President’s public condemnation of his own Fed chair.
As with many stories involving Donald Trump, the drama overshadows any discussion of public policy. While the Fed is designed to run on autopilot, allowing technocrats to worry about inflation and the money supply so the rest of us don’t have to, it’s worthwhile to have some grasp the political and economic dynamics of the current clash between the Fed and the Executive Branch.
Trump has a fairly binary view of how the federal funds rate works (assuming he has any understanding). When rates are low, the economy is good, and vice versa. This explains his lambasting of the low-rate Fed policy under Obama as “reckless” and his demand that rates be kept low during his tenure. This isn’t exactly how it works, but there’s a strong case to be made that American workers would benefit if Trump gets his way on monetary policy.
The “low rates equals good economy” line of thinking comes from the fact that a higher federal funds rate generally slows down the pace at which money flows throughout the economy. When rates are higher, less people and businesses take out loans, which means less investment, consumption, and spending. The tapering of spending is meant to keep inflation at a manageable level without an upsurge in unemployment. Despite the dry, academic, and technocratic view of the Federal Reserve held by most Americans, the majority of its mandate can be understood as simply managing the see-saw of inflation and unemployment.
However, there are a number of things wrong with this simple approach to monetary economics. Firstly, as the current economy demonstrates, low unemployment (which currently sits below 3.8%) and manageable inflation doesn’t necessarily equate to an economically healthy population. Wage growth, a hotly debated topic among economists and economic commentators, doesn’t fit into this binary view of the economy. While the last ten years has seen a lengthy and (until recently) steady expansion, wages have only started to tick up in the last year or so. Not only does this contradict how wages are typically supposed to operate in a healthy environment, it means growth is leaving massive swaths of the population behind.
In theory, the lower unemployment goes, the higher wages will rise as employers compete for workers by offering higher compensation. Economist Jared Bernstein writes:
The key point is well understood: tight labor markets boost worker pay. Why? Because, especially in an economy where just 6.4 percent of private-sector workers are union members, most U.S. workers have low bargaining clout, meaning unless employers are forced to compete for them, there’s little to channel much of the gains from growth their way.
But research finds that it’s not just tight labor markets that makes a difference to wage growth: it’s persistently tight labor markets. It wasn’t until year 10 of this expansion that we began to see notably stronger wage gains. In other words, the goal for creating high-pressure labor markets isn’t just getting to full employment. It’s staying there!
Workers shouldn’t have to wait around for the latest quarterly jobs report to find out whether they’re getting a raise, and the fact that it’s taken ten years for long-term wage growth to exceed 0% is ridiculous. It’s a sign of something much worse underneath the surface of our economic data, but whatever that “something” is, raising the federal funds rate and slowing the pace of the economy will wipe out the already meager gains that American workers have made through low unemployment.
While these gains can be viewed as a delayed, albeit positive development, others see it as a harbinger of inflation. As Economics professor Karl Smith explains: “The Fed fears that those higher wages will fuel too much inflation as employers try to recoup their higher costs by raising prices.” However, inflation isn’t even close to being problematic in today’s environment. Bernstein writes that “…there’s been virtually no evidence of wage gains bleeding into price gains,” seeing as inflation has consistently held just below its target of 2% annual growth despite the recent increases in wages.
There may not have been any wage gains had the Fed begun raising rates earlier, as tradition and theory instructed them to do. The exact point at which low unemployment fails to spur inflation, referred to as the “natural rate” of unemployment, is generally considered to be around 5.5% depending on when the Fed is making its estimates. The Fed intentionally allowed unemployment to fall below this rate, with no resulting inflation to speak of.
Dean Baker, of the Center for Economic and Policy Research, frames the impact of this policy in an illustrative way:
I remember a few years back the Republican Congress was pushing a budget that called for a 5 percent cut in the food stamp budget. This cut would have been roughly equal to $4 billion a year or 0.1 percent of the federal budget. The liberal punditry and many inside the Beltway groups rallied to beat back the proposed cut…the difference between 3.8 percent unemployment and 5.5 percent unemployment probably means close to a hundred times as much in terms of wage income for low- and moderate-income households. It would be nice if it got almost as much attention.
Elsewhere, he notes that Alan Greenspan faced a similar decision in the 1990’s. Rather than increasing interest rates when unemployment approached 5.5%, he “allowed the unemployment to fall to 4.0 percent as a year-round average in 2000. This gave us the late 1990s boom, the only period of sustained real wage growth for those at the middle and bottom of the wage ladder since the early 1970s”. Karl Smith notes that the 1990’s and the present-day are the only two periods in the last five decades in which we saw “a sustained increase in real median weekly earnings…What these periods have in common is the willingness of the Federal Reserve to tolerate a prolonged period of low unemployment.”
The debate over whether to ditch the idea of a “natural rate” should have been had after the 1990’s boom, but being late to fix public policy is better than leaving it broken. Last year, former IMF chief economist Olivier Blanchard became one of the most high-profile economists to question whether a “natural rate” exists at all. He writes that central banks should “keep an open mind and put some weight on the alternatives” to the current framework. He continued: “I believe that there is a strong case, although not an overwhelming case, to allow US output to exceed potential for some time, so as to reintegrate some of the workers who left the labor force during the last ten years.”
If both the 1990’s and the 2010’s saw high wages and low inflation accompany low unemployment, we can at least admit that some tinkering must be done with the mechanics of our monetary policy. Prosperity should come from following good models, not ignoring bad ones and hoping for the best.
Despite the pathetic state of wage growth in the long term, the data presented shouldn’t be cause for concern. Wages have grown while prices have stayed steady, resulting in higher real incomes and qualities of life for American workers. Raising the Fed’s rate now will only eliminate these gains.
However, what should be a concern is that the Fed instructed itself to not let unemployment fall below 5.5%. Perhaps the “natural rate” hypothesis is false, or perhaps the employment-inflation relationship exists how we’ve always understood it to, albeit at a lower rate of unemployment. Regardless, the inconsistencies between theory and reality demand a re-evaluation of how the Fed approaches monetary policy.