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The seven-year itch (at the Fed)

Sources: BLS, BEA, Federal Reserve

With today’s solid jobs report—payrolls up 211,000, unemployment steady at 5 percent, wages up 2.3 percent over the past year—the likelihood that the Federal Reserve will raise interest rates at its Dec. 15 meeting is all but locked in.

The question at hand is thus…why? Based on the data, raising the interest rate it controls to slow the economy is not at all a slam dunk. So what’s behind this craze to raise?

I’ll trot out the data in a moment, but for all the reams of deep econometric analysis of this question, I’ve come to think the answer is deceptively simple: Fed officials just want to take the question of “when’s liftoff, damnit?!” off the table. T’was lo these seven years ago, on Dec. 15, 2008, that the Federal Reserve set the target interest rate to zero. This was in the depths of the Great Recession, when the Federal Open Market Committee (FOMC) told us of their anticipation that “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

As far as Fed officials are concerned, “some time” is over, and if the data aren’t quite there yet, well, too bad. The committee’s got a seven-year itch, and it’s going to scratch it. That almost certainly means a quarter-point increase is coming later this month, and given the extent to which they’ve telegraphed this move, I don’t think it’s going to have a large, negative impact on the economy. It will very slightly raise mortgage rates, bond yields, and so on, and that will slightly dampen economic activity. What matters now is the so-called “normalization path:” how fast the Fed raises the rate in subsequent meetings.

I’ve got three figures that argue for a shallow path back to normal levels of the Fed funds rate, but if that’s to happen, Chair Janet Yellen and others on the committee who recognize that we’re not yet at full employment must tell the inflation hawks to back the *%$! off. They got their damn increase. It’s time to get back on a data-driven path.

The first figure–up above–shows that even as unemployment has fallen steeply such that it’s now at the level the Fed considers to be full employment, inflation has, if anything, decelerated, the opposite of what their models would predict. The Fed is working from a playbook where once you hit full employment, the rate of inflation will start to increase, and they’ve therefore got to start raising rates.

But not only has inflation failed to perk up—as you can see, they’ve been missing their 2 percent inflation target for years now—but as the next figure shows, their predictions that inflationary pressures were about to hit the scene have been consistently wrong (the figure is from an important piece by economist Andy Levin). The dashed lines show the FOMC forecasts, which have consistently predicted that the increase in inflation was just around the corner.

What you have here instead is the forecasters’ version of Charlie Brown and the football. And that means something’s wrong with their playbook. Unemployment and inflation are simply not doing their usual dance, and that warrants a major rethink by macroeconomists for whom this relationship has long been a stalwart guidepost.

The first figure also includes wage growth, which has picked up a bit as the job market has tightened. That’s what you’d expect, and, if anything, corroborates my priors that if we want working people to start seeing their fair share of this recovery showing up in their paychecks, we’ve got to get to, and stay at, full employment. And you don’t see wage growth bleeding into price growth.

The next figure shows the history of the Fed’s interest rate plotted against the output gap. The latter is the percent difference between actual GDP and potential GDP, which is what GDP would be if the economy were running on full steam. Recessions, by definition, are sharp declines in the output gap, which then climbs back to zero if the expansion takes hold. So, for the most part, these two variables are positively correlated: big output gap, Fed lowers rates to lower the cost of borrowing and hasten the recovery (the early 1980s were unique in that the Fed raised like crazy to break double-digit inflation, thus inducing the downturn).

You can see where the seven-year itch comes from: this period of the Fed rate at zero has been unprecedented. But you’ll also note that the output gap is just as unprecedented–it’s never taken this long to close it. And the gap is still significant, at around 3 percent, or over half-a-trillion bucks of missing output. As Levin points out in the above link, the Fed has typically not raised when there’s this much missing GDP in the mix.

One final data point in today’s jobs report: the under-employment rate, which I view as a more informative indicator of the degree of labor market slack right now. Along with the unemployed, it includes part-timers who’d rather be full-timers, and some who’ve left the labor force but might come back if job opportunities were there. It ticked up to 9.9 percent last month.

There’s no official measure of what underemployment should be at full employment, but I estimate it to be 8.5 percent. So by this more encompassing measure of slack, we’re a ways from full employment.

As you see, there are a lot of data saying “don’t raise.” On the other side, unemployment is low, job growth is solid and steady, the economic expansion is “mature” (it’s been in place for over six years) and the Fed’s got a seven-year itch they’re about to scratch. Stay tuned for what happens next.