Today the Federal Reserve — as expected, but somewhat puzzlingly — decided to raise its key benchmark interest rate by 0.25 percentage points, acting to somewhat slow the pace of job creation, which has already been somewhat slower this year than last.
“The stance of monetary policy remains accommodative,” according to the Fed’s statement, meaning that rates are still low by historical standards, “thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.”
The basic context is that the unemployment rate is now low, the economy continues to add jobs each month, and the Fed is eager to “normalize” policy by both raising interest rates and starting the work of undoing the various rounds of quantitative easing that were put in place during the peak years of financial crisis and recession.
At the same time, there’s something fundamentally odd about the decision. People generally enjoy lower interest rates and more rapid economic growth. The standard worry is that if you keep rates too low for too long that inflation will get out of control. But inflation is not, currently, out of control. Indeed, the Personal Consumption Expenditure deflator that the Fed uses to measure inflation is running below the Fed’s 2 percent target and has been for years. And the Fed’s own projections don’t show inflation going over 2 percent at any time in the future.
Inflation is low and has been for a while
The Fed statement is accompanied by a helpful chart showing that inflation was below the target in 2012, 2013, 2014, 2015, and 2016, and is expected to remain below target in 2017.
Many scholars advocate a strategy of “level targeting” in which the Fed would “make up” for past undershooting of the two percent target with future overshooting.
Janet Yellen, most of her colleagues on the Federal Reserve, and the Fed’s professional staff all reject that idea. But their forecasts show inflation not only not-overshooting, but continuing to stay below target in 2017 and 2018.
It’s easy to see why the Fed might shy away from controversial extraordinary measures with the unemployment rate relatively low, but given the lack of inflation, it’s difficult to understand the urgency the Fed perceives about raising rates and slowing the economy down.
Job growth is slowing and it’s a problem
Donald Trump has been calling on the media to spend more time dwelling on the relatively benign economic situation lately. But while it’s true that stock markets have reached all-time highs and the unemployment rate is now relatively low, the pace of job creation has slowed down in recent months.
That’s in part a natural consequence of the low unemployment rate. With fewer idle workers out there to hire, it’s harder for the economy to add jobs at a rapid clip.
At the same time, on the campaign trail Trump often dwelled on the issue of labor force participation, which he noted had fallen considerably over the course of the 21st century. His musings on this were overstated and tended to ignore the rising share of elderly people in the population. But even demographically adjusted, it is true that labor force participation has slipped considerably since the turn of the millennium. If the economy were nonetheless facing high inflation, one might say we simply need to accept that as a fact of life.
But with inflation restrained, there’s reason to hope that pro-growth monetary policy would encourage more of those workers off the sidelines — or encourage employers to adopt training and recruiting strategies that get them off the sidelines. The Fed’s apparent lack of interest in such an approach, choosing instead to take the unemployment rate at face value and begin fighting the phantom menace of inflation, poses a huge risk of leaving millions of able-bodied non-workers permanently locked out of the labor market.