The Federal Reserve took a historic step at the end of last year when it raised interest rates for the first time since the 2008 financial crisis took down the U.S. economy. The move was intended to signal the central bank's confidence in the progress of the nation's recovery, but since then, its faith has been tested. A slowdown in the broader global economy and turmoil in financial markets have kept the Fed from moving again, and investors are overwhelmingly betting that the central bank will stay its hand once more when it meets in June.
But Jeffrey Lacker, president of the Federal Reserve of Richmond, says there are good arguments for raising rates next month, and he laid out them out in an interview with The Washington Post in his top-floor office at the bank's headquarters overlooking the James River. Lacker has led the Richmond Fed since 2004 and has been a vocal critic of the central bank's easy-money stance. Now, he says the Fed might be falling behind the curve as the economy strengthens.
This transcript has been edited for length and clarity and includes comments from a follow-up email.
Q: You have said that the path outlined in December — four rate hikes for this year — is still appropriate. What are you seeing for June?
I never completely make up my mind before a meeting, but at this point it looks to me as if the case for raising rates looks to be pretty strong in June. Inflation is moving decidedly toward 2 percent. Labor markets have tightened very significantly. The concerns, the downside risks that we saw at the very beginning of this year, have dissipated. And we’re very far away from the benchmarks that we have to guide where rates ought to be. To me that adds up to a pretty strong case for a June move. But as I said, I don’t make up my mind until the meeting comes.
Markets are not expecting a move in June. Why do you think there’s been such a disconnect between the Fed’s own expectations of where it sees interest rates headed and where the market thinks the Fed will be headed?
That’s a good question. I think there’s a risk involved when you delay interest-rate increases when uncertainty rises, when risks present themselves, but don’t make up the ground when those risks subside. To do that imparts a one-way ratchet effect to interest rates, and over time, it can lead interest rates to just drift away from our benchmarks. I think markets may be extrapolating from our recent behavior and thinking all we do is delay. We never recover.
Do you think the Fed needs to catch up?
I think we’re in that situation now. If you look at the benchmarks for where rates ought to be, these are relationships between employment and inflation and the funds rate that have characterized our behavior when we’ve been successful in the past. Those benchmarks indicate that we ought to have moved several times by now. The longer we delay, the more we’re falling behind. Having delayed in the first part of the year, I think we need to be thinking about catching up, making up ground.
If some of your colleagues are worried that the economy is still too fragile and the global outlook too uncertain to withstand one additional rate hike, what do you think the impact of more aggressive rate hikes might be?
I can’t speak for my colleagues, and we generally don’t do that. I think the U.S. economy is relatively strong. I think the first quarter seems pretty clearly to be a transitory dip in growth. Consumer spending growth maybe dipped a bit, but the fundamentals look strong. Housing is making strong contributions to growth. Labor markets are, I think, very tight. I think we’re clearly seeing now signs of increasing wage inflation, and that matches up well with the anecdotal reports that we have been hearing for a year and a half of broadening and deepening wage pressures in our district at least. That’s now lining up with the national data. So I think the U.S. economy has shown itself to be pretty resilient since the turmoil that showed itself last June and August.
The downside scenarios just haven’t materialized. While there’s always some room for uncertainty, there are always things that are uncertain about the months ahead. I think it’s a folly to think that there’s a lot more clarity right around the corner. Someone famous once said that waiting for uncertainty to resolve doesn’t really work because down the road you’re still uncertain. You’re just uncertain about different things.
The uncertainty that could be looming down the road in June could be "Brexit." Sounds as if you’re not too worried about the impact that could have on the U.S. economy.
It has the potential for being a major source of uncertainty going into the June meeting. We generally don’t perturb our policy on the basis of potential elections, either domestic or foreign. I don’t see it as having outsize implications for U.S. monetary policy.
How did you read the most recent jobs report?
I thought it was a fine report. Sure, it was below consensus expectations, but by an amount that was statistically insignificant. I’ve been surprised by some of the commentary about it. It showed strengthening wage gains, it showed broad-based payroll gains, hours worked. I think it was a good report.
And besides, if we do see a deceleration in payroll growth, at this point, that would most likely reflect running out of workers. It would most likely reflect the tightening labor market.
Has the Fed’s reaction function changed? Has your reaction function changed?
I think the question about reaction functions is a good one. These benchmarks I’m talking about come out of the reaction functions that have been shown to have worked well in the past. That evidence is both empirical in the sense that the times that we followed that pattern of behavior we did pretty well. Times that we departed, we did pretty poorly. There’s good economic grounds, there’s good theoretical grounds, for thinking that as well.
What are the potential risks of waiting too long and getting too far behind the curve?
Monetary conditions can shift relatively rapidly. Maybe not overnight, but over the course of six, nine, 12 months, conditions can shift pretty decidedly. A good example of that was mid-2003 to 2004. We swung 180 degrees from a fear of deflation to strong evidence that inflation was rising and we needed to tighten policy. I think we’re in a situation like that now. Although people are very concerned about inflation being below 2 percent, it’s not below by much. It’s been increasing. If we don’t adjust policy in a timely way, what we could find is that inflation pressures emerge pretty rapidly and that we have to act vigorously to counteract, and that brings along financial market turmoil of the like we saw in 1994, which wouldn’t be the best way to do policy.
Your colleagues on the other end of the spectrum would say there have been warnings about the risk of inflation through this recovery. They haven’t materialized yet. Why do you think they might start now?
Early in the recovery, these benchmarks I indicated were at far lower levels. That’s why we kept interest rates at zero. Earlier in this expansion, there were concerns that emanated from the size of our balance sheet, which had grown large because we were in uncharted territory. Because inflation in the past has often been associated with overly large monetary expansions, people thought there was a risk of our large balance sheet spilling over and sparking inflation.
I think people understand better the degree to which the banking system is capable of absorbing the large quantities of reserves we injected without prompting a large expansion of the money supply that consumers and businesses use. I think we understand now why quantitative easing didn’t spark inflation, so I think it makes sense.
This is a very different environment. Our benchmarks are indicating that significantly higher rates are warranted. We have a very tight labor market. We have a pickup in wage inflation. Inflation is rising. It’s still below 2 percent, but still. It’s a very different situation than it was a couple of years ago.
As the Fed looks toward potentially hiking rates again, what type of communication do you expect to see? The statement that we got in April seemed to be fairly neutral in tone.
I think it’s useful if markets are well-aligned with our expectations going into a meeting, but I don’t think if they’re not, it’s a show-stopper. The prospect of surprising markets shouldn’t stay our hand if we think an increase in rates is warranted. My colleagues and I have been sharing our views about our outlook, and I think that’s the natural way to go about trying to better align market expectations with ours.
Do you worry that the long period between the first and the second hikes affects Fed credibility?
Lacker: This was bound to be a period in which our reaction function was in question, and people were going to be avidly interested in the pattern of how we would act to incoming data. We’ve emphasized data dependence. Data dependence in principle is one thing. But how are you going to react? What does data dependence look like?
This was bound to be a year in which markets would grope for an understanding of the pattern of behavior we’re going to display in the future. I think as a policymaker, you've got to take that into account and realize that every action or inaction is teaching markets something about your future behavior.
Donald Trump was recently on CNBC discussing the Fed, saying that he might replace replace Fed Chair Janet Yellen if he became president. How do you view the discussion of the Fed in this current campaign season?
I’m not going to comment on utterances of presidential candidates. Monetary policy is and should remain a nonpartisan task. The Federal Reserve should remain a nonpartisan institution. We’re an important institution, so people get asked about us. It’s natural for them to say what they think. I have no objections about that. We need to remain nonpartisan. It’s part of our independence and our ability to take a long-run view for us to stay above the fray.
Our independence comes along with a very serious obligation to be as transparent with the American public as possible. If there are steps we could take to be more transparent, I would favor them. I get very concerned about proposals to alter our governance. At times when we’re about to, or are in the process of, raising rates, it seems those are times when Congress takes an interest in our governance all of a sudden.
In the 1960s, this happened quite notably, and threats to alter our governance were part of the pressure that was put on the Fed to delay raising rates. And the result was a disaster.
I’m open to alternative ways to structure our governance, but I think that our independence of electoral political pressures is essential to good monetary policy in the long run. I haven’t seen any governance proposals that wouldn’t threaten that and wouldn’t erode our independence.
Democratic presidential candidates Hillary Clinton and Bernie Sanders support removing bankers from the board of directors of the Fed's reserve banks. What do you think of this proposal?
Bankers are on our boards because the Federal Reserve banks were set up to function as clearinghouses for the banks, and we still do. Bankers provide valuable expertise relevant to the banking and payment operations of the reserve banks, which as you know are quite extensive. We clear over $4 trillion in payments each day. Bankers are also quite knowledgeable about economic trends in their local markets, and so they provide very useful input to our understanding of our regional economies. I should mention that bankers, like all of our directors, are excluded from any role in supervision or regulation of banks, however.
You recently wrote that some banks may opt out of membership of the Federal Reserve system because of new government regulations. Explain your concern.
The FAST Act reduced the statutory return on member banks’ paid-in capital. This precedent is likely to discourage banks from becoming or remaining members of the Federal Reserve System, which could lead to an erosion of Reserve Bank capital over time. That capital helps protect the Fed’s balance sheet from fluctuations in the value of our assets, which could otherwise erode confidence in the Fed. We’re down to $5 billion in paid-in capital and another $10 billion in surplus for a $4.5 trillion portfolio — that’s not much.
One of the big puzzles facing economists is low productivity. What do you think are the main drivers?
I think it will take a good deal of research. There are a lot of plausible candidates out there, but it’s not terribly clear at this point what’s driving this.
There have been swings in productivity growth in the past that have lasted a decade or more. We seem to be in a fairly prolonged dip in productivity growth. I’m optimistic about productivity growth in the longer run. I think productivity growth generally depends on the generation of ideas and the implementation of those ideas. I think we have all the ingredients for generating very useful ideas here. This continues to be a relatively good place to implement good ideas.