The Fed Should Stay Put
By Nayyer Ali MD
On September 16 and 17 the US Federal Reserve will hold a key meeting to decide on interest rate policy. Since the economy collapsed in late 2008, the Federal Reserve cut short term rates to zero interest in an attempt to revive the economy. Because there was so much systemic damage from the banking crisis, bad debts, and households that could not afford to borrow or spend, these low rates have only slowly healed the economy. Recovery was boosted somewhat by Obama’s stimulus plan, but that was a trillion dollars to small for the job, and once the Republicans took over the House in 2010, their obsession with short term deficits prevented any further stimulus.
Despite these headwinds the economy has slowly healed. There are 13 million more people working now than in 2010, and the unemployment rate in August was down to 5.1%. There are many voices, particularly among conservative commentators such as the Wall Street Journal editors, calling for the Federal Reserve to start raising interest rates.
To do so would be a mistake. The only reason for the Fed to raise rates is if it wants to slow down the economy, to prevent it from overheating. If that happens then inflation can start to rise to levels that are undesirable. This happened in the 1970’s when the Federal Reserve failed to raise rates soon enough after the end of the 1974 recession, and by 1980 inflation was running over 10%, and helped cause Jimmy Carter’s loss to Ronald Reagan.
So the key issue is whether the economy is nearing capacity and in danger of overheating, where too much credit is being created and starts chasing too few goods and services bidding prices higher. If we look at broader economic indicators other than the unemployment rate (which is very low now at 5.1%), that is not the picture we see. While the measured rate of unemployment is low, it is not counting several million Americans who left the workforce entirely during the Great Recession and have not returned. They are on the sidelines ready to work. In 2007, at the last peak, there were 138 million employed Americans. 8 years later we now have only 143 million. Given population growth since then, there is at least another 3 million potential workers that are on the sidelines, and the Fed should wait till they are back on the job before it assumes the economy needs to be cooled off a bit.
In addition, core inflation is running only 1.7% per year currently, and has slowed down since 2012. Overall inflation (which includes the collapse in oil prices in 2014) is essentially zero over the last 12 months and is expected to rise about .4% for 2015 as a whole. The Federal Reserve has a goal of keeping inflation at around 2%, which does not suggest that we are anywhere near a takeoff in inflation. In fact, too many people are treating that 2% target as a ceiling rather than an average over several years.
The Federal Reserve should be in no hurry to raise rates. The economy still has excess capacity, inflation is minimal, and workers have yet to see much in the way of pay increases. If workers were really in short supply we should be seeing a rise in wages as employers start bidding for qualified help. That has not happened yet. In the late 1990’s, the unemployment rate dropped to 5% but Alan Greenspan and the Federal Reserve did not jump the gun. They allowed the economy to expand further, driving unemployment down to 4% and it was a time of rising wages with low inflation for the American economy. Janet Yellen, the current Fed Chairwoman, should follow that example. There is still enough slack in the American economy to justify waiting another six months.