Markets are panicking, but Boston Federal Reserve Bank President Eric Rosengren, one of the central bank's leading doves, thinks monetary policy should stay steady-as-she-goes.
Specifically, he thinks the Federal Reserve should end its quantitative easing, or QE, as planned — although he wouldn't rule out the possibility that they could do more of it if inflation falls further. Instead, he thinks the Fed should keep interest rates low for as long as wage and price inflation are too, even if that means unemployment falls below what the Fed thinks "full employment" might be. He also said that, now that the Fed's bond-buying is drawing to a close, that the evidence shows it's helped the economy, and, in his opinion, helped reduce inequality, too. And finally, he said that if interest rates get stuck at zero during the next recession, it might be time for the Fed to think about increasing its 2 percent inflation target.
Here are the six big takeaways from my conversation with him over the weekend.
1. Rosengren doesn't think low inflation expectations today justify more QE. Right on cue, markets have remembered that Europe is stuck in a depression that it isn't escaping anytime soon. That, together with a few weaker-than-expected U.S. data points, has been enough to send markets down, and up, and down, and up again. The end result is that markets now expect as little inflation as they have the last few times the Fed has eased policy.
So does that mean more QE is on the table? No, at least not anytime soon. "Inflation breakevens," Rosengren explained, "are based on the pricing of Treasury securities and Treasury Inflation-Protected Securities (TIPS). So if you think about what the implication of significant financial market turbulence is, particularly about Europe, it's for foreign investors to buy Treasury securities. They disproportionately buy regular Treasury securities, so the flight to safety is going to start changing the relative prices of Treasury securities" and make it look like markets expect less inflation. But "if you look at inflation expectations based more on surveys, there's been a little bit of softening, but certainly nothing consistent with the kind of movements we've seen in the [Treasury] breakevens. So I wouldn't overreact to one or two weeks of sharp movements, because I think there are plenty of other reasons to explain" them.
2. But Rosengren does say the Fed could do more QE if inflation keeps falling. "I don't expect that we're going to need another QE," he told me, "but if we see inflation expectations becoming unhinged on the downside, and particularly if we we worried that we were going to hit a deflationary period, then I certainly wouldn't rule out the possibility that we'd do another QE." But, if instead, "we're very slowly getting up to 2 percent inflation, then an appropriate tool may be lower [interest rates] for longer, and then fairly gradual increases."
3. Rosengren also thinks the evidence is clear that QE works. "My own view is that QE has been quite effective. When we started it, the unemployment rate was much higher. Our unemployment has down where it hasn't in many parts of the world." And you can see its impact in things like "auto sales that have been very strong" and "some pretty significant movement up in housing prices and residential investment that's been much stronger than we anticipated."
4. And he thinks that QE has helped reduce inequality. "There's no disputing the fact that asset prices have gone up as a result of what we're doing," Rosengren acknowledged, and that "disproportionately helps somebody who has enough wealth that they have, for example, stocks." But "on balance" he "thinks the net benefits outweigh the net costs in terms of income inequality" for a simple reason: "the one thing that really contributes to income inequality is to have no income at all."
Or, as he put it, "being unemployed is the ultimate inequality. It not only destroys your income, but probably destroys your wealth, and frequently has big impacts on your entire family." And that means, "to the extent that QE and the other tools that we're using bring the unemployment rate down, that disproportionately helps people at the lower end of the [income] distribution." Furthermore, "if you think about who's the lender and the creditor, the creditor who's lending the funds tends to be at the upper end of the distribution." So "low interest rates are good for the people at the bottom of the distribution" who need to borrow to go school or buy a car or a house.
5. Unemployment might be able to go lower than the Fed thinks. The Boston Fed's "own estimate for full employment is 5.25 percent," which puts Rosengren "on the low side" of everybody else. But, as he noted, "we're at 5.9 percent unemployment now, and there's not much wage pressure." Indeed, "if anything," he went on, "I would expect inflation maybe drifting down over the next two quarters, because not only are wages not going up, but oil prices and other commodities are going down. So it may be that when we get to 5.25 percent unemployment, if we're not having any inflationary pressure, I'd be willing to probe further."
That's because full employment is "not a theoretical concept, it's really an empirical observation: at what point is there enough tightness in the labor market that we start seeing wages and prices going up consistent with a 2 percent inflation target." And the answer is: it depends. Since there are still so many people working part-time for economic reasons, "it may be that when we hit 5.25 percent unemployment, there's actually more slack, which would mean we'd be comfortable waiting a little longer before we should fully tighten up monetary policy."
6. Rosengren thinks the Fed should consider increasing its 2 percent inflation target if interest rates fall to zero during the next recession. Central bankers hate being stuck at what they call the "zero lower bound," or ZLB, and what everyone else just calls zero interest rates. That's because it prevents them from using the tool they're most comfortable with—rate cuts—to boost the economy. (The Fed can't cut rates into negative territory, at least not for very long, since people would move their money into cash rather than lose money in interest). And so, as we've seen the last six years, a zero interest rate economy tends to be one, since there isn't enough stimulus, where inflation is too low and unemployment is too high. Or, to use a technical term, there's a lost decade.
So what if next time isn't different? The Fed seems to think, partly due to our aging workforce, that the economy's long-term potential has fallen, and with it, long-term interest rates. That means rates won't be as high the next time the Fed needs to start cutting them—assuming they even get that high—and we might be right back at the ZLB. Rosengren agreed that since "productivity's down, and we keep a 2 percent inflation target, but [longer-term rates] have drifted down by 25 basis points" that it "somewhat increases the probability that we hit the zero lower bound again." And, significantly, he said that "if we keep getting close to the zero lower bound, we'll have to think about whether we've actually set an inflation target that's too low." Higher inflation, of course, would mean higher interest rates too—hopefully enough to keep us away from zero for a long, long time.