The Case for Pausing the Interest-Rate Climb
The Federal Reserve has done an outstanding job fulfilling its dual mandate of maximum employment and price stability. To keep the economy in this happy Goldilocks position, the Fed should hold off on raising rates at its December meeting and consider incoming data before deciding when—or even whether—to resume tightening.
For much of the postcrisis period, the Fed relied on forward guidance—publicly committing not to raise the federal-funds rate without signaling a shift long in advance. This assured markets that short-term rates would stay near zero until there were clear, persistent signs that the economy had fully recovered. Yet even then the Fed was a poor predictor of its own behavior, frequently releasing "dot plot" forecasts that overestimated how early the rate increases would begin and how steep they would be.
The Fed's poor predictions of its own actions were actually a sign of the soundness of its decision making. Instead of sticking to a rigid plan, it changed course based on new developments, including unexpected headwinds from the global economy.
With interest rates in positive territory, forward guidance is no longer needed. Accordingly, Fed Chairman Jerome Powell has de-emphasized dot-plot forecasts, saying "We don't have the ability to see that far into the future, so I really wouldn't put a lot in that."
Certain strong economic indicators may encourage the Fed to stay the course of normalizing rates. The state of the labor market looks a lot like full employment, with the jobless rate near the lowest level on record, and employment for prime-age workers back to its prerecession rate. Workers are showing their confidence by quitting their jobs at high rates, and employers are posting record numbers of openings.
Wage growth has picked up but is still below the rates seen in the late 1990s. This slower growth is not necessarily evidence of a slack labor market. Productivity growth is running around 1 percent, compared with about 3 percent in the late 1990s, which explains lower wage growth. Recent wage gains have been fastest for workers in the bottom quintile. Overall, this is what a hot labor market looks like in an economy that still suffers from low productivity growth.
These factors underscore the importance of staying ahead of possible inflation, which is harder to counteract after it starts to accelerate. But that goal needs to be weighed against the possibility of accidentally preventing an extended period of high employment by raising rates too soon. Allowing lower-interest borrowing to continue could keep the economy steady, bringing more people back to the labor market and potentially raising real wages even higher.
The Fed's interest-rate increases earlier this year balanced this uncertainty in a reasonable way, keeping monetary conditions stimulative while taking care not to overheat. The Fed's plan to raise rates in December also looked reasonable three months ago—but it looks much less reasonable now.
Since late August financial conditions have tightened substantially: The S&P 500 is down 8 percent, long-term interest rates are up about 0.2 percentage point, and the trade-weighted dollar has strengthened by 2 percent. Collectively these changes are equivalent to about two federal-funds rate hikes. The Fed's governors might have thought in September that another increase would be needed by year's end, but they should acknowledge that the market beat them to it.
At the same time, the global economy is weakening. Germany and Japan posted negative growth rates in the third quarter; growth in China slowed to its lowest pace, on a year-over-year basis, since the global financial crisis; and last month the International Monetary Fund reduced its forecast for global growth in 2018 compared with its projection this summer. The Fed wisely slowed its normalization plan to accord with similar global economic tremors in 2015-16, and it should do so again at the coming meeting.
The biggest reason for caution is surprisingly low inflation. The core consumer-price index, which excludes the volatile food and energy components, has increased at a mere 1.6 percent annual rate since July. That's below the 2.3 percent it grew over the previous 12 months, and lower than most analysts expected when the Fed set out on its current course. This inflation slowdown is puzzling given the tightening labor market and rising wage growth, and it may prove transitory. Financial markets, forecasters and the public haven't revised down their predictions for inflation. But there would be little downside to the Fed waiting a few months to find out.
Looking forward, fiscal stimulus will be much smaller in 2019 than this year, and the trade war could take an increasing toll on growth. These facts aren't new, but information about how the economy responds to them will be, and it will be important to monitor this new data going forward.
John Maynard Keynes is reported, perhaps apocryphally, to have said that he was willing to change his mind when the facts changed. One reason the economy is so strong now is that the Fed has been willing to change its mind as the facts develop. That adaptability makes policy more predictable, not less, because it enables monetary policy to act as a hedge against economic developments.
It's time for the Fed's governors to remind us that they are not on a preset course dictated by hawks or by doves, but instead are acting like owls—peering through the dark and updating their movements based on the latest scurryings of the mice.