Los Angeles Times, August 19, 2016
Almost 20 years ago, in September 1996, the Federal Reserve’s Board of Governors had an internal dispute over whether to raise interest rates.
Most economic models predicted that inflation would spiral upward if the unemployment rate was much below 6.0 percent, and it had just reached 5.1 percent. Some board members, including present-day Fed Chairwoman Janet Yellen, argued that the Fed should therefore raise interest rates to push the unemployment rate up to a safer level. They understood that higher interest rates would mean slower growth and fewer jobs, but they viewed the risk of inflation as more dangerous.
Thankfully, Alan Greenspan, the chairman at the time, was not convinced. He won the fight, and the Fed did not raise interest rates.
With the benefit of hindsight, we know that was the right decision: The result was four years of extraordinarily low unemployment and extraordinary growth.
Instead of getting back towards the “safe” 6.0 percent rate, the unemployment rate continued to fall throughout the rest of the decade. It reached 4.0 percent as a year-round average for 2000. And the benefits went disproportionately to the most disadvantaged. The unemployment rate for African Americans had been 11.5 percent in 1994 when the overall unemployment rate was at the 6.0 percent target. In 2000, it averaged 7.6 percent.
The gains for African American teens were even more dramatic, with the unemployment rate falling from 35.2 percent in 1994 to 24.3 percent in 2000.
The stronger labor market also translated into real wage growth for those at the middle and bottom of the wage ladder. Wages for workers at the 20th percentile of the wage distribution (80 percent of workers earn more, 20 percent earn less) rose by 11.9 percent between 1995 and 2000. The wages of workers at the 50th percentile (half of workers earn more and half earn less) rose by 7.7 percent. This was the only time in the last four decades where workers at the middle and bottom of the wage distribution saw sustained wage growth.
As a result of Greenspan’s decision not to raise interest rates, and thereby allow the unemployment rate to continue to fall, the economy was also 10.7 percent larger in 2000 than the Congressional Budget Office had projected for that year back in 1996. In today’s economy, that would translate into almost $1.8 trillion in additional income — or $5,600 per person.
The reason this history lesson is relevant today is that the Fed is once again debating its interest rate policy. Later this month, it will be sponsoring a conference in Jackson Hole, Wyo., with many of the world’s most prominent economists. The central item on the agenda will be whether the Fed should consider the current 4.9 percent unemployment rate as a floor. Those arguing this position claim that inflation will begin to spiral upward if the unemployment rate falls further, and perhaps even if it remains at 4.9 percent.
Yet many economists, including many at the Fed, still see plenty of slack in the U.S. economy. They will argue that the Fed should allow the economy to grow further and the labor market to tighten — and they should get their way.
In spite of models that project rising inflation, there is even less evidence of inflation being a problem today than in the 1990s. In fact, inflation is still well below the Fed’s target and is actually slowing in the latest data.
Janet Yellen is an outstanding economist whom we are fortunate to have as Fed chair. But she made the wrong call on this issue 20 years ago. Let’s hope she gets it right today.