November 22, 2016
In the summer of 1996, the Los Angeles Times was warning its readers about “the shadow of rising inflation” [1] looming over U.S. financial markets “like the mammoth alien spacecrafts of Independence Day,” the blockbuster movie of the time. The article suggested the danger of inflation was imminent and concluded that “for the shell-shocked bond market, there will be an assumption that either the Fed is going to tighten credit, or inflation is going to continue to rise, or both.”
The general consensus in 1996 was that the economy was at, or very close to full employment. Unemployment was at its lowest level in years, which was about 5.4 percent. In their outlook for 1996–2000, the Congressional Budget Office (CBO) estimated the non-accelerating inflation rate of unemployment (NAIRU) was 6 percent. The CBO also warned that “if rapid growth continues, inflationary pressures will mount.”
Martin Feldstein, then President of the National Bureau of Economic Research, expressed his concern with unemployment being too low as early as March 1995. Feldstein stated that while “people have argued that we can tolerate much lower interest rates than in past U.S. historical experience,” he did not “think that’s true.” Feldstein declared the unemployment rate of 5.4 percent as being “well below the unemployment rate that even the Congressional Budget Office (CBO) would call full employment” and urged the Fed to severely tighten monetary policy. Feldstein estimated NAIRU at 6.23 percent and concluded that the possibility of being wrong was “quite low.”
The New York Times presented the case against a rate hike in September 1996, yet it ended its article by admitting defeat and stating “still, most analysts on Wall Street are predicting the Federal Reserve will raise interest rates.” [2] The only possible explanation for Alan Greenspan, then chairman of the Federal Reserve, not raising interest rates in the fall of 1996 was he “would like to stay on the sidelines in an election year.” [3]
Despite the mounting pressure, Greenspan held interest rates steady at the September 1996 meeting, and for the rest of that year. Following the September decision, the Los Angeles Times [4] accused Greenspan of “simply bowing to politics,” “avoiding becoming an issue in the presidential race,” and concluded that “the Fed, instead of raising rates, has crossed its fingers.”
In retrospect, there is little doubt that Greenspan made the right move. A month later, in November 1996, the Wall Street Journal shifted its tone and praised the Fed’s decision to not tighten monetary policy, saying “it looks like the Fed bet right.” [5] Later that month, the U.S. the OECD “predicted another couple years of full employment with fairly low inflation.” [6]
While 6 percent was considered to be the NAIRU in 1996, the unemployment rate continued to decline in the following years. In 2000, it reached the much lower level of 4 percent, without triggering any significant increase in inflation. This allowed for the creation of an additional 4.2 million jobs and proved the economy can operate at a much lower unemployment rate than previously believed, without any significant inflationary pressures.
In late 1996, current Fed Chair Janet Yellen was a Fed governor. When these debates were taking place, Yellen perceived the fear of inflation as somewhat exaggerated. She did admit that low unemployment “poses an inflation risk” but also believed “the market is overreacting on the question of upside risks.” However, in the summer of 1996 Yellen did call for being “vigilant” on inflation since the economy was “close to full employment.” [7]
Now, the economy is in a similar situation to the summer of 1996. The unemployment rate has been steadily declining, and there is pressure on the Fed to tighten monetary policy. However, the unemployment rate is still close to 5 percent. Given the fact that we’ve had an unemployment rate of 4 percent without triggering inflation before, there appears to be room for unemployment to continue to fall.
Perhaps more importantly, we have seen a huge number of prime age workers (ages 25 to 54) drop out of the labor force. The employment-to-population ratio for this group is still two full percentage points below its pre-recession peaks. It is four percentage points below its peak in 2000. This amounts to 2.5 million to 5.0 million fewer people holding jobs.
While Yellen said in a speech in early October she would consider running “a high-pressure economy,” in which she would allow the unemployment rate to further drop, it now seems clear the Fed is expected to raise interest rates when it meets in December. In testimony before Congress, Yellen stated “U.S. economic growth appears to have picked up” and hinted the FOMC would raise rates at its next meeting.
In the same speech, Yellen also admitted “it is troubling that unemployment rates for African Americans and Hispanics remain higher than for the nation overall, and that the annual income of the median African American household and the median Hispanic household is still well below the median income of other U.S. households. However, if Yellen goes ahead and tightens monetary policy, not only with a December rate hike but locking in future hikes, it will be preventing further declines in unemployment. This disproportionately undercuts the ability of African American and Hispanic households to get jobs and pay increases.
The Fed resisted the consensus among economists and in policy debates by allowing the economy to continue to expand, and unemployment to fall, in the mid and late 1990s. There was an enormous dividend in growth that disproportionately benefited the most disadvantaged. There is good reason to believe that resisting the consensus and allowing employment to grow further may again offer a large dividend.
[1] Los Angeles Time, July 7th 1996, “Coming Soon to an Economy Near You: Inflation,” Tom Petruno
[2] New York Times, September 12th 1996, “The Case Against a Rate Rise Attracts a Respectable Crowd,” Peter Passell
[3] Wall Street Journal, August 21st 1996, “Fed Leaves Interest Rates as They Are,” John R. Wilke
[4] Los Angeles Times, September 25th 1996, “In Holding Steady on Interest Rates, Fed Takes a Big Chance,” Tom Petruno
[5] Wall Street Journal, November 4th 1996, “Fed Hits Bull’s-Eye on Economic Growth”
[6] Wall Street Journal, November 13th 1996, “U.S Wins ‘A’ From OECD; Low Inflation is Seen”
[7] Washington Post, June 6th 1996, “Neither the Numbers, Nor the Fed Members Signal Rate Hikes: Growth, Inflation Realities,” John M Berry
