Factors for the Fed to Consider

August 29, 2016

When the first and so far only federal funds hike of the current cycle was implemented last December, U.S. real GDP had only risen 0.9% at an annualized rate between the summer and autumn quarters. At the start of some previous tightening cycles, U.S. real GDP had advanced much more quickly than 0.9%, to wit by 2.3% in the first quarter of 1988, 4.0% in the first quarter of 1994, 3.3% in the second quarter of 1999, and 3.0% in the second quarter of 2004.

The ensuing two quarters after last December’s interest rate hike were also very weak, including 1.2% last quarter. Growth over the most recent three quarters was merely 0.9% annualized, a pace that historically would have been considered dangerously near to stall speed.

America’s unemployment rate has been 5.0% or less since October 2015 and below 6.0% since October 2014. To prevent a cumulating upswing in the jobless rate, non-farm payroll employment only needs to expand about 100K per month or even somewhat less. Employment has been growing safely above that threshold.

Nonfarm payroll jobs rose 1.72% over the past twelve reported months and expanded 2.10% in the previous year through July 2015. That is more than sufficient for Fed officials to agree that discernible progress has been made toward achieving their mandate of maximizing employment without jeopardizing the other mandate of price stability.

A longer view of the trend in U.S. jobs discredits the notion that the level of jobs is crossing into excessive territory. By coincidence, nonfarm payroll jobs grew at a virtual identical pace in the 1980s and 1990s, that is at 1.841% per year between December 1979 and December 1989 and by 1.837% per year between December 1989 and December 1999 at which point 130,0532,000 jobs existed. The July 2016 employment level of 144,448,000 workers represents a net 0.613%  per annum advance over the 16 years and 7 months since-end-1999. This is just a third as strong as in the final two decades of the 20th century. Even in the most recent two years, jobs grew only marginally faster than the norm between end-1979 and end-1999.  Put differently, if jobs instead had maintained the earlier average pace into the 21st century, last month’s employment level would have been 176,645,000. That hypothetical level is 32,200,000, or 22.2%, greater than the actual level.

Global growth conditions are very fragile. Emerging markets are expanding much more slowly than in 2008-09, and Euroland and Japan are in a malaise. Not only is GDP in 2016 expanding at less than 2% in both economies, but such in 2017 is likely in each place to amount to only about 1.0%.

The U.S. economy is in the eighth year of the current economic upswing. It’s safe to assume that we are closer to the start of the next recession than the 2Q09 end of the last one. High on the Fed’s agenda as attested by talk at the Jackson Hole central banking symposium is preparing the monetary policy tool kit for the next downturn. The federal funds rate target is now just 0.25-0.50%. Previous rate loosening cycles began from 9.75% in February 1989, 6.0% in July 1995, 5.5% in September 1998, 6.5% in January 2001 and 5.5% in September 2007.

While there are other tools in the kit than the federal funds rate, a desperate need exists to lift the funds rate level before the onset of the next recession. To be sure, this would not be necessary if one could count on an apolitical and flexible fiscal policy. At low interest rates as existed in the depression and early 2009, fiscal policy is better suited to support aggregate demand. In the current environment, it would take a much greater turnover of the Congress than seems conceivable for the fiscal lever to change in such a way as to be a game changer.

Ordinarily a 25 basis point hike of the federal funds target to 0.50-075% would not seem to threaten continuing positive economic growth. But remember, the economy is already growing weakly and in an unbalanced way overly reliant on personal consumption.  The prices of equities and Treasuries already seem excessive. While fear of Brexit’s immediate fallout has receded, the confidence of investors, businessmen, and consumers has not fully recovered from that surprise. Fed officials have used utmost caution so far not to raise the interest rate if either financial markets or economic data are flashing caution flags. That hasn’t been the case in August, and if conditions continue as they’ve been, it makes sense to tighten on September 21st. It would be a shame to let such an opportunity go to waste.

The worst thing that could happen, however, is a miscalculation such that a rate hike, however small and however low the level, becomes a trigger for the next recession. If not for that risk, it might have made sense in fact for the Fed to be acting in increments of 50 basis points rather than 25 bps. The risk may be small in probability terms but catastrophic in terms of its consequences. More than anything, the U.S. and world economies need the U.S. to keep growing for several more years. With inflation still below target and having been under target for several years already, the tradeoff between a policy that errs on the side of causing inflation to rise above 2.0% or of causing a new downturn in inflation clearly favors the latter in terms of minimizing long-term damage.

A final consideration for Fed officials is the dollar. The U.S. currency is already overvalued. Fed tightening juxtaposed against likely easier stances by the European Central Bank and the Bank of Japan would be yet another channel through which a shifting Fed policy might produce a greater-than-assumed drag on U.S. growth.

There’s much to consider, and that doesn’t take into account what a Congress hostile to the Federal Reserve might do to strip the central bank of its independence next year. Fed officials have to get policy right for the sake of the U.S. and world economies. They also have to be perceived doing the right thing to guard their own institutional role.

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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