The Fed Missed Its Chance. Now What?

The business cycle is peaking, with no interest-rate increase. The central bank has blown it. Still, better late than never.

By Edward P. Lazear
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The Federal Reserve is in a tough spot. When the central bank’s policy makers meet next week, many observers expect them to leave interest rates untouched, perhaps citing the shock of Britain’s vote to leave the European Union.

The difficulty is that many indicators, particularly from the labor market, suggest that the U.S. economy is peaking and that the recovery from the Great Recession is nearly complete. This is bad news—and not only because the summit is too low. It also means the Fed has blown it.

At this point in the business cycle, the Fed would normally be holding steady, looking ahead to a time when it might cut interest rates. Instead it is preparing for a prolonged path of increases, even though the best time to raise rates may have already passed.

Historically, the central bank increases its target federal-funds rate as the economy recovers, beginning within two to three years of the recession’s end—but often sooner. It then cuts the target around the time that the peak is reached. The exception is the current recovery, during which the target and actual rates remained flat for more than seven years. After only a minor increase in December, rates are still near zero. The Fed has fallen seriously behind the curve.

No one can divine exactly when the economy will peak. But most of the evidence suggests that the moment is near. The unemployment rate is 4.9%, and it hit 4.7% in May, figures consistent with full employment.

Job growth tells the same story. When the economy is in recovery mode, job growth exceeds population growth, making up for the employment lost during the recession. That slows as the peak approaches, until job growth just keeps pace with population growth. That’s where we are now.


To keep up with population growth, the economy needs to create about 130,000 jobs a month. During the past three months, job growth averaged 147,000. That’s down from an average of 229,000 a month last year. The trend suggests that the labor market is in full-employment equilibrium.

Further evidence suggesting the economy has begun to level off: The hiring rate reported by the Bureau of Labor Statistics now hovers at 3.5%, down from a high of 3.8% last December.

Or consider wage growth. During the early stages of recovery, real wages are flat, but they increase as the labor market tightens and full employment approaches. Although wage growth has been less than spectacular, the Bureau of Labor Statistics reports it at 2.6% during the past year, above the rate of inflation.

Finally, GDP growth is steady or slowing. The first quarter rate of 1.1% is below the already anemic recovery average. Figures for the second quarter, even if considerably better, won’t do much to change that picture.

At this stage of the business cycle, it is unrealistic to expect that the economy will soon become more robust and better able to withstand rate increases. Even if we are at a growth plateau rather than a peak, the postrecession drop in unemployment to 4.9% from 10% will not be matched by a future drop to 0%.

Yet the Fed’s unwillingness to raise rates can be explained, if not defended. If this is a peak, it is too low a summit. Growth rates have fallen short of the prerecession average and cannot make up for lost ground. Further, the labor market has not returned to full strength: The employment rate, which reports the ratio of those with jobs to those in the working-age population, was 63.4% in December 2006 but now stands at only 59.6%. Some of this difference reflects an increasing numbers of retirees. But the rate for those of prime working age, 25 to 54, is also 2 percentage points below prerecession highs. Additionally, the hiring rate during this recovery never reached the 4% peak attained in 2006, during the previous boom.

Each time it appears appropriate to raise rates, some new shock hits the world economy, Brexit being the most recent example. Fundamentally, the Fed fears a repeat of 1938, when a recovering economy was sent into a second strong contraction as a result of central-bank tightening.

Still, interest-rate increases are overdue. If this is the peak of a business cycle, or close to it, rates should have gone up long ago. The Fed has already waited too long to move back to a more normal posture, one that would permit aggressive monetary policy when it is next needed.

Now the Fed’s position must be better late than never—hoping that the costs of poor timing will be small.


Mr. Lazear, a former chairman of the Council of Economic Advisers (2006-09), is a professor at Stanford University’s Graduate School of Business and a Hoover Institution fellow.

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