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The Fed's constant chatter about higher interest rates is holding back the recovery

Jack Lew Presides Over Financial Stability Oversight Council Meeting
Fed Chair Janet Yellen’s frequent comments about higher interest rates aren’t good for economic growth.
Photo by Chip Somodevilla/Getty Images

This afternoon, the Federal Reserve will announce whether it's going to raise interest rates for the second time since 2008. And despite months of chatter from Fed officials about impending rate hikes, it looks like they’re likely to hold off on any increase for now.

When the Fed last raised rates in December 2015, the central bank predicted it would raise rates four more times in 2016. In March, it revised the forecast down to just two interest rate hikes for 2016. Last month, Fed Chair Janet Yellen said that the Fed was likely to raise rates "gradually and cautiously" over the next few months — perhaps as soon as the June meeting that’s happening this week.

But then the Labor Department released the worst jobs report in years, killing chatter about a June rate hike. Higher interest rates slow economic growth, and Fed officials are expected to conclude that the economy can’t afford higher interest rates right now.

This pattern — the Fed talking about imminent interest rate hikes but then delaying them due to disappointing economic performance — has been playing out for a couple of years. A lot of commentators simply treat it as bad luck, with the Fed as a mere spectator. But that misunderstands what's going on.

In reality, the Fed’s constant chatter about raising rates is itself an important cause of the economy’s sluggish performance. Markets and business leaders pay close attention to Fed statements. When Yellen signals that higher interest rates — and, consequently, slower growth — are imminent, companies respond by cutting investment spending. The result is a self-defeating feedback loop.

For the Fed, words often speak louder than actions

To understand why Fed statements can have such a big impact, it's helpful to think about things from the perspective of a business considering whether to start building a new factory. One thing the company’s CEO will likely do is ask an economist for a forecast of economic conditions. It makes more sense to open a factory if the economy is on the verge of a major boom than a recession.

Of course, no one — not even someone with a PhD in economics — knows exactly what’s going to happen to the economy. But Fed policy has a big impact on the economy's trajectory.

A perceptive forecaster will notice that the Fed seems determined to raise interest rates (and slow the economy) as soon as doing so won’t be disastrous. This means that the odds of a 1990s-style boom are fairly low, and the odds of a premature rate hike triggering a recession is higher than it would otherwise be.

Hence, every time Yellen reiterates that interest rates are likely to happen soon, the nation’s economic forecasters revise their forecasts downward a little bit. That causes the nation’s businesses to spend a little less on new investments. Less investing spending, in turn, means the economy grows a little bit more slowly. And a slowing economy forces the Fed to delay its interest rate hike.

In other words, the fact that the Fed constantly has to delay interest rate hikes in response to bad economic news isn’t just a matter of bad luck — it’s partly a result of the Fed’s own actions. We’re getting a slow economic recovery because the Fed has been signaling that it wants a slow recovery — or at least that it doesn't care enough about faster growth to make that its priority.

If the Fed wants a more robust economic recovery, it needs to convince markets that it wants a faster recovery. To do this, Yellen and other Fed officials need to stop talking about interest rate hikes and instead talk about how they're dissatisfied with the current pace of economic growth. They could say they want to see higher growth and are willing to risk moderately higher inflation in order to get it. They might even want to hint that their next move might be a rate cut rather than a rate hike.

Ironically, this strategy could actually get the Fed back to "normal" interest rate levels more quickly than its current policy of constantly talking about — and then delaying — interest rate hikes. The Fed keeps delaying interest rate hikes because the economy is underperforming, and the economy keeps underperforming because businesses don’t believe the Fed will allow faster growth. But if economic growth and inflation start exceeding expectations, then the Fed will be able to raise rates without triggering fears of more years of poor economic performance.

The Fed needs a better communication strategy

The larger problem here is the Fed’s ad hoc strategy for setting interest rates and explaining future decisions to the markets. At a fundamental level, the Fed’s job is to set clear and realistic expectations for the economy’s growth. If businesses believe the economy will grow quickly, they’ll invest more and help make that forecast come true.

But right now the Fed is doing a terrible job of this. The economy constantly falls short of the Fed’s projections, and the Fed keeps talking about interest rate hikes anyway. As a result, its projections have less and less credibility, and the economy has gotten stuck in a low-inflation, low-growth, low–interest rate rut.

A better approach would be for the Fed to explicitly put economic growth at the center of its decision-making. The best way to do this is with a technique called nominal GDP targeting, which has been endorsed by prominent economists like former Obama adviser Christina Romer. Under this approach, the Fed would commit to keeping the total amount of spending in the economy — in nominal terms, not adjusted for inflation — growing at 5 percent per year. If that means cutting interest rates or even restarting unconventional programs like quantitative easing, that’s what the Fed would do.

If the Fed were able to make this pledge credible, it would reverse the current bad equilibrium in which business pessimism causes the economy to consistently undershoot the Fed’s projections. If businesses believed the economy were really going to grow as fast as the Fed projected — because the Fed was committed to doing whatever it takes to hit the target — then businesses would be more inclined to spend money on new stores and factories. Growing business confidence, in turn, would help the Fed reach its targets. This would be a virtuous cycle, instead of the vicious cycle the Fed is stuck in right now.