As expected, the Federal Reserve just raised the benchmark interest rate it controls again. Prediction markets assigned a 95 percent probability of a quarter-point hike, which was exactly what the Fed just announced. Had the board not raised the rate, it would have surprised the markets, and while that can sometimes be a useful tactic, there was no reason to do so today.
There’s been some pushback to the hike by economists who saw no reason for the Fed to tap the brakes. Why slow down a labor market that has finally tightened up enough to deliver some real wage gains to middle- and lower-paid workers? (This may reflect the view of Neel Kashkari, president of the Minneapolis Fed, the sole committee member to vote against today’s hike.)
Josh Bivens at EPI has the particularly interesting view that letting the economy run hot would induce a virtuous cycle of greater investment and faster productivity, a point I’ll return to below. (I’ll also be interviewing Josh about it in a forthcoming column).
Still, I can see the Fed’s rationale — the figures below show a mild acceleration in gobs of both wage and price data series — and as long as th Fed governors stop, look around and confirm that their “normalization” campaign isn’t undermining the more broadly shared income gains now occurring before they raise again, I don’t think today’s small, expected rate bump will make a great difference to forthcoming economic outcomes.
But what’s most interesting about the role of the Fed right now is a big argument that may well be brewing between President Trump and Fed Chair Janet L. Yellen.
This is just the latest version of a very old fight. Presidents want unbridled growth, jobs and incomes; Fed boards want to balance growth with price stability. But like every other old fight, in the current context it comes with a Trumpian twist. Not only is Trump less likely to honor the traditional independence of the Fed by avoiding overt political pressure, he’s sitting on two (soon to be three) appointments to the Fed’s Board of Governors, so he can pack the court, as it were.
However, there’s a way in which Trump and Yellen are not that far apart, and it has to do with the economy’s speed limit.
Think for a moment of an economy’s capacity the way you’d think of a glass of water. You can pour water into the glass until it reaches the brim. Someone who wants the biggest possible drink may nudge you to keep pouring, but at some point you must stop or be ready to clean up a mess (“water” in this somewhat clunky analogy represents consumer and investment demand).
At that point, the only way to get a bigger drink (more demand) is to use a bigger glass. In economic terms, you get a bigger glass through expanding economic capacity, and there are two broad ways to do that: productivity and more labor supply. The table below shows the growth rates of both of these variables over 10-year periods. Note that their growth rates add up to output growth. In the most recent period, the slowdowns in both productivity and hours worked, and thus output, are striking.
So if you want more output — a bigger glass — you need either faster productivity growth, growth in the labor force (or hours worked), or some combination of both. When Trump says he wants to move from the current 2 percent to 3 or 4 percent annual growth, this, whether he knows it or not, is what he’s talking about.
Yellen and Co. are working off the assumption that the glass is pretty much full. One could raise legitimate questions about that conclusion. While the overall unemployment rate is, at 4.7 percent, equal to the rate they believe to be consistent with full employment and stable prices, black unemployment is 8.1 percent. The underemployment rate, at 9.2 percent, is still above where it should be at full employment (8.5 percent, by my estimation). Be that as it may, those price and wage trends shown above led the Fed to believe that more water would spill over the brim — i.e., at some point, more demand just yields more inflation, not more jobs and higher incomes.
But if the Fed were to believe that the glass is larger — that productivity or labor force growth were speeding up — it would be comfortable with a bigger drink.
And with that, we have arrived at the fundamental problem of Trump vs. Yellen, meaning where things could get uncomfortable. The problem is that the stuff that team Trump thinks will make the glass bigger — regressive tax cuts and deregulation — won’t work, and the Fed knows it. Tax cuts on high-income people might generate a little growth bump, but as much as supply-siders wish it were so, they won’t boost productivity. Financial market deregulation is, if anything, associated with underpriced risk, asset bubbles and, ultimately, recession.
What would work? Bivens raises an intriguing idea, one I too have written about: More water itself makes the glass bigger. If the Fed were to let the economy run hot, higher real wages would squeeze profits. Producers would then be motivated to make productivity-enhancing investments to maintain profit margins amid rising labor costs. One can also easily imagine higher wages pulling more sideliners back into the workforce.
I will note that column 4 in the table above is consistent with these ideas: When the economy spent more time at full employment, productivity grew faster. But the truth is that we need more evidence, and economists aren’t generally very good at explaining what makes productivity growth speed up or slow down.
What we do know is that neither the Trump policies we’ve heard about so far nor the political gridlock that continues to dominate the federal government are pro-growth. Yes, he’s talked about infrastructure investment, and a smart plan to improve the quality of our public capital probably would make the water glass a bit larger. But Trump’s specific plan — tax credits that would fund a bunch of stuff that’s going to happen anyway (and thus have no extra impact on growth) — is ill-conceived, and the topic seems to have dropped off the policy map.
Meanwhile, I predict that any day now, if he hasn’t already beaten me to it, Trump starts tweet-shaming the Fed for raising rates and thus thwarting his goal of faster growth. And tweeting, need I remind anyone, is no substitute for actual pro-growth policies.
Data note: Columns 1-3 are all 10-year growth rates (using natural logs) from the non-farm, business sector of the economy (source: BLS). Column 4 compares CBO estimates of the “natural rate” of unemployment to the actual rate by quarter, then counts the share of quarters above or below that rate (sources: CBO, BLS).