July 29, 2019
A Washington Post piece on the issues surrounding a rate cut this week by the Federal Reserve Board missed many important points. First, and most importantly, it never once mentioned that inflation has been persistently below the Fed’s 2.0 percent target. This matters both for the Fed’s credibility and more importantly as a protection policy in the next downturn.
On the first point, the Fed has repeatedly stated that its 2.0 percent inflation target is an average, not a ceiling. That means that the inflation rate must occasionally rise above 2.0 percent in order for the average to be 2.0 percent. Inflation in the core personal consumption deflator, the rate targeted by the Fed, has not exceeded 2.0 percent since the Fed Chair Ben Bernanke adopted it as an official target in 2012. If Fed policy is not consistent with achieving the 2.0 percent inflation target, then markets will not believe the Fed is committed to this target.
The other side of this is that we know that there will be another recession at some point. Inflation almost always falls in a recession. If we go into a recession with a 1.5 percent inflation rate (the figure for the last twelve months) then we are likely to see inflation fall very close to zero in a downturn. This matters because the Fed would like to have a large negative real interest rate (the nominal rate minus the inflation rate) in a recession. If inflation is near zero, then even with a zero federal funds rate, the real interest rate is only slightly negative.
The piece was also misleading when discussing mortgage interest rates. After telling readers that rates are already low, it presents a quote from a housing industry economist:
“‘A Fed rate cut will have zero impact on the housing market,’ said Tendayi Kapfidze, chief economist at Lending Tree. ‘Mortgage rates are already at three-year lows.'”
Mortgage rates dropped in the spring precisely because markets were anticipating Fed rate cuts this summer. It is virtually certain that if the Fed does not cut rates, and indicates that no cuts are on the horizon, then mortgage rates will rise back to their levels of earlier this year (roughly half a percentage point on a 30-year mortgage).
The piece also suggests that labor shortages are a problem for the economy. There are few sectors where wages are rising especially rapidly, the most obvious sign of a labor shortage. In fact, overall wage growth has slowed in recent months, suggesting increasing slack in the labor market.
The most obvious reason to lower rates is that in an economy with no evidence of inflationary pressure, there really is no reason not to try to push demand higher. This will allow more people to get jobs and improve workers’ bargaining position. The benefits from a tighter labor market accrue disproportionately to those with the least power in the labor market: minorities, people with less education, people with criminal records.
It is difficult to design social programs that effectively and efficiently benefit these groups, it is easy for the Fed to lower interest rates and let them get jobs and pay increases.
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