In early December, just after Donald Trump pulled off his Carrier job stunt, saving on the order of 800 jobs at an air conditioner factory in Indiana, an arm of the Federal government took a step to destroy more than one hundred times as many jobs over the next year or two. If that sounds odd, then you must not have heard about the Federal Reserve Board’s decision to raise its key interest rate by a quarter of a percentage point. Few areas of economic policy are as poorly understood as the structure and powers of the Federal Reserve Board. This is partly due to the archaic structure of an institution that was put in place more than a century ago. Without doubt, some of its operations are inherently complicated. A large part of the story is a failure of the media to accurately convey the importance of its actions.
The Fed affects the economy through its impact on interest rates. Its primary tool is the federal funds rate, which is the interest rate that banks pay each other in overnight money markets on borrowed reserves. When the Fed raised this rate in December, the expectation was that it would lead to an increase in a wide variety of interest rates that consumers, businesses, and governments pay for loans. For example, it would mean higher interest rates on car loans and home mortgages. Businesses looking to borrow money from banks or in credit markets could expect to pay higher interest rates. City and state governments issuing bonds to finance infrastructure could expect to pay higher interest rates, as would the Federal Government on the money it borrows.
The exact relationship between the overnight rate set by the Fed and these other interest rates is complicated by a variety of factors, but as a general rule a higher federal fund rate will lead to higher interest rates throughout the economy. The basic economic logic is that when the price of an item rises, in this case credit, the demand will drop. In other words, consumers, businesses, and governments will borrow less money and therefore spend less money. That will lead to less demand in the economy, and therefore less output and employment.
The impact of the Fed’s quarter point rate hike could easily shave 0.1 to 0.2 percentage points off the economy’s growth rate over the course of 2017. That would likely mean 100,000 to 200,000 fewer jobs than would otherwise be created, or 125 to 250 Carrier job events in reverse.
The folks at the Fed are not just being scrooges trying to keep people from having jobs as an end in itself. The Fed is acting to ensure that inflation does not become a serious problem for the economy, as it was in the 1970s. By slowing the rate of job creation and weakening the labor market, the Fed is deliberately trying to reduce workers’ bargaining power. This slows the rate of wage growth, which is generally seen as the driving force in inflation. In effect, the Fed was concerned that the economy was creating jobs at a rate that is too rapid and would cause inflation to start spiraling upward, if left unchecked.
Trading Off Lower Unemployment for a Greater Risk of Inflation
While most economists would agree with some version of the story above — that at lower unemployment rates there is a larger risk of rising inflation — there are major disputes about the extent of the trade-offs and more importantly, how seriously to view the relative costs and benefits. Ever since the Great Recession, the inflation rate has been very low. If there was reason to believe that inflation could suddenly spike — shooting up several percentage points from its current rate of less than 2.0 percent — then it might be reasonable for the Fed to be cautious and to maintain more slack in the labor market than necessary, just to ensure that inflation doesn’t get out of control.
However, there is little basis for concern about sudden spikes in the inflation rate. We haven’t seen large jumps in inflation except in response to events like surging oil prices, which would not be much affected by Fed policy in any case. Most models show that inflation responds slowly to an overly tight labor market. This means that if the Fed were sleeping on the job and allowed the labor market to get tight enough to starting pushing up the inflation rate, we would be looking at price increases on the order of tenths of a percentage point a year, not a sudden surge to double digit territory.
On the other hand, there are enormous potential benefits from allowing the unemployment rate to continue to fall and for more people to get jobs. As a rule of thumb, the unemployment rate for African American workers is twice the unemployment rate for white workers, with the unemployment rate for African American teens roughly six times the unemployment rate for white workers. The unemployment rate for Hispanic workers tends to be roughly 1.5 times the unemployment rate for white workers, although this relationship is more variable. This means that people who most benefit from reduced unemployment are the most disadvantaged groups in society.
This shows up in patterns of wage growth as well. Workers at the middle and bottom of the wage distribution benefit most from a tight labor market. The only time in the last forty years when these workers saw sustained gains in real wages was the low unemployment years of the late 1990s. While this was a prosperous period for workers in general, workers at the bottom of the wage distribution saw the biggest wage gains.
Given the enormous benefits of lower unemployment, it might seem that it would be worth the risk of slightly higher inflation to press the labor market as far as we can. There are few if any social programs that would provide as much benefit to lower income populations as an increase in African American employment by two percentage points and an increase in the employment rate of African American teens of six percentage points, especially if the pay for these jobs rose by 12 percent, which happened between 1995 and 2000.
Who Rules the Fed?
Not all groups in society view the trade-off between unemployment and the risk of inflation in the same way. In particular, the financial sector is often quite worried about inflation. The reason is that the value of its outstanding loans is reduced if the inflation rate ends up being higher than anticipated. Unfortunately, the financial sector has a disproportionate say in the decisions of the Fed on interest rates. The key decision-making body, the Fed’s Open Market Committee, includes the presidents of the Fed’s twelve regional banks, along with the Fed’s seven governors, who are appointed by the president and approved by the Senate. (Only five of the bank presidents have votes at each meeting, but all twelve take part in the debate.) The process by which the regional bank presidents are picked is complicated, but it is dominated by the banks in the region. Unsurprisingly, bank presidents tend to represent the interests of the financial industry.
While the governors are appointed through the political process, even they tend to be overly concerned about the interests of the financial industry. Part of the reason is that the financial industry is actively following every move by the Fed, while the bulk of the population pays little attention.
This point was driven home to me back in 1994 when I had the opportunity to meet with Alan Blinder and Janet Yellen (the current Fed chair), when both were members of the Fed’s Board of Governors. The economy was in a similar situation as it is today, with the unemployment rate falling towards 6.0 percent, a level where most economists believed that inflation would become a problem. I went there with two colleagues to argue that the consensus in the profession was wrong, and that the unemployment rate could continue to fall without triggering inflation.
When I couldn’t convince Blinder and Yellen about the limited risk of inflation from a lower unemployment rate, I asked them what would be the problem with taking a gamble and allowing the unemployment rate to fall to 5.0 percent, a full percentage point below the consensus estimate of the target unemployment at the time.
Blinder noted that their models would project a modest rise in the inflation rate. I then challenged him as to why this would be a serious problem, since the Fed could always raise interest rates, forcing the unemployment rate back up and heading off further increases in the inflation rate. Blinder responded that the Fed is an institution that is committed to price stability. I pointed out that it was an institution that at the time was also legally committed to a target of 4.0 percent unemployment.
Blinder told me that no one takes the 4.0 percent unemployment target seriously. I then suggested that he doesn’t have to take the commitment to price stability seriously, to which he responded, “Yes, I do.”
The path the Fed followed in the years after this meeting offers lessons for the current situation. The Fed raised rates sharply, as we feared, pushing its overnight rate from 3.0 percent to 6.0 percent in a bit more than a year. This slowed the economy as predicted.
However in the summer of 1995, with the unemployment rate still under the widely accepted 6.0 percent targeted rate, Alan Greenspan pushed through a drop in interest rates. For all his many flaws, Greenspan has never been a conventional economist. As the growth rate picked up and the unemployment rate began to decline further, Greenspan resisted demands from other Fed members to raise interest rates. Rather than relying on the models, Greenspan argued that there was little evidence of inflationary pressures, and therefore no reason to slow the economy.
Not only did this allow for the late 1990s boom and the sharp reduction in unemployment and wage growth noted earlier, it also set a new benchmark for how low the unemployment rate could go. While I could not convince Blinder and Yellen that the economy could sustain lower rates of unemployment without spiraling inflation, the economy won this argument.
When the unemployment rate averaged 4.0 percent for a full year in 2000, with little evidence of any uptick in inflation, it became pretty hard to sustain the case for a 6.0 percent floor on the unemployment rate. The Congressional Budget Office and other official forecasters adjusted downward their estimates of the lowest sustainable unemployment rate to 4.0 percent, based on this experience.
In the current situation, the issue is more the employment rate, the percentage of people who have jobs, rather than the unemployment rate. The 4.7 percent unemployment rate for December is not especially high, but since the Great Recession millions of prime age workers (ages 25 to 54) have simply given up looking for work and dropped out of the labor market. The employment rate for these workers is two full percentage points below the pre-recession level, and almost four percentage points below the 2000 level.
It seems implausible that so many people in their prime working years don’t feel like working, or that they have suddenly lost the skills needed to get jobs. The more likely scenario is that there is not enough demand in the economy. Not seeing jobs available, these workers don’t bother to look.
We will never know for sure whether or not this explanation is correct if the Fed slams on the brake and doesn’t test the limits of the labor market. If the Fed is prepared to allow the economy to grow more rapidly and for more jobs to be created, it will have more benefits for the country’s workers than many thousands of Trump’s Carrier shows.
Thanks to Dean and the folks at CEPR for this one.