It’s a Good Thing the Fed Has Missed its Chance to Raise Rates. Here’s Why.
The Fed's main mission is low inflation and high employment, not boosting interest rates
By Greg Ip
A shockingly weak May jobs report knocked the Federal Reserve off what looked like a clear course to raise interest rates in the next few months. Up and down Wall Street, you could hear the groans: once again the Fed missed its chance.
For two years now the Fed has charted a path to steadily raise interest rates, but has regularly pulled back because the economy suddenly weakened, inflation dropped, or the financial markets acted up. The Fed still thinks rates will gradually rise as unemployment falls, which leaves it “looking for windows of opportunity to raise rates,” as my colleague Jon Hilsenrath puts it.
Critics say it has boxed itself in: By simply preparing to raise rates, the Fed triggers conditions that make it impossible to follow through.
Yet this logic has perverse implications. It says the Fed tightens when it can, not when it should.
This confuses the tool of monetary policy, interest rates, with its goal, which is low unemployment and stable inflation around 2%.
The Fed’s rate target was near zero from 2008 to 2015 and, after just one increase, sits between 0.25% and 0.5%. So isn’t it self-evident that rates have to rise? Isn’t that what the Fed believes, with its dot plots tracing out a steadily rising path for the Fed funds target?
Actually, no: The right level of rates will have been achieved when the economy is at full employment and inflation at 2%. A few years ago officials thought that magic interest rate (they prefer the term “neutral” or “equilibrium rate”) was 4%. Now they think it’s 3.3%. In her speech Monday, Janet Yellen, the Fed chairwoman, suggested it may now be less than 2%.
These are all guesses. For all they know the right number is 0.25%. No economic law dictates what Fed funds rate should correspond to a fully employed economy.
To say the Fed missed its chance is to argue that rates today should already be higher. But if they were, then the slowdown (if indeed there is one) now underway would have come sooner.
Wouldn’t higher rates, though, have given the Fed more ammunition to deal with such a slowdown?
Yes, but that would be a Pyrrhic victory. It means the economy’s starting point would have been feebler, with unemployment at, say, 6% instead of near 5%. That interest-rate ammunition would have been purchased at a steep price in terms of foregone jobs and incomes.
There are two reasons why the Fed might wish it had raised rates sooner. One is that inflation quickly rises past its 2% target, requiring a much more dramatic tightening and possibly recession to get it back. That looks exceedingly unlikely. In fact, long-term inflation expectations, already below 2%, are dropping further.
The other is that the prolonged period of zero interest rates feeds destabilizing financial speculation, which eventually reverses, violently, leaving the economy worse off than if the Fed had tamped things down sooner.
This second concern is not a trivial risk. The right response is for the Fed to weigh the benefits of keeping rates low, which are higher employment now, against the costs, which is a slightly higher probability of a large loss of employment later. In 2014 that tradeoff may have favored moving as markets were quite frothy. Since then, the mere expectation of tightening has cooled risk-taking, and that is probably why the economy, with a lag, has slowed.
Ms. Yellen indicated that notwithstanding May’s lousy jobs numbers, she still thinks the labor market will get stronger. She’s probably right. On the other hand, according to J.P. Morgan, the odds of recession in the coming year have risen to an uncomfortably high 36%. If in fact a recession comes to pass, one thing is certain: The Fed will be glad it didn’t tighten even more.