News & Analysis

The Federal Reserve’s Need for a Cohesive Approach to Interest Rates

 

105473146-1537991487303gettyimages-1041066332Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, D.C., Sept. 26, 2018. (Andrew Harrer/Bloomberg)

Federal Reserve officials agreed today to keep interest rates steady amid pressure from the White House and economists to keep interest rates low. Jerome Powell and the Fed’s Board of Governors have been criticized for their so-called lackluster, and, at times, inhibitory, stance towards economic growth in the last year. In a statement following the 2-day meeting, the Federal Open Market Committee (FOMC), a board of 12 governors charged with addressing monetary policy, stated: “The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes.”

In a two-part tweet on Tuesday morning, President Trump said the economy could “go up like a rocket” if the Fed keeps rate low.

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President Trump has been a chief critic of Federal Reserve chair Jerome Powell, even reportedly saying last month that he is “stuck with” Powell. While the Federal Reserve is an independent agency not under official direction by the executive branch, it is still often politically influenced.

To the committee’s benefit, the U.S. economy is currently working in contradiction of traditional economic theories that state low unemployment should produce higher rates of inflation. William Phillips, an early-20th century New Zealand economist, uncovered this very phenomenon and created the “Phillips curve.” His underlying theory is that when there are fewer unemployed workers and numerous unfilled jobs, companies will have to increase wages, thus boosting inflation, or vice versa. There has been growing skepticism toward the curve in recent years, however.

20171104_WOC123Photo: The Economist

As seen in the above graph, this relationship seemingly no longer exists. From 1975 to 1984, there was a prominent negative linear relationship between inflation and unemployment; but more recently, this line has flattened out.

The Fed seems to still be unsure how they will address the changing economic paradigm. The FOMC’s July 2017 published minutes state, “Participants…indicated that their views of the outlook for economic growth and the labor market were little changed, on balance, since the June FOMC meeting. Participants continued to expect that, with gradual adjustments in the stance of monetary policy, economic activity would expand at a moderate pace and labor market conditions would strengthen somewhat further.” To paraphrase, the committee predicted low unemployment rates would heat up the economy and increase inflation to their target. We now know this never occurred.

On December 19, 2018, the Feds’ credibility came under question again following Chairman Jerome Powell’s announcement of another interest rate hike and quantitative tightening, a contractionary monetary policy tool used to decrease the amount of liquidity on the open market. The Dow, NASDAQ, and S&P 500 all hit lows for 2018 and Treasury yields on the 2-year and 10-year government bonds flattened as well.  

The Federal Reserve continues to mistakenly assert that the underlying principles of the curve are still valid and in action. Jerome Powell answered a PBS News Hour moderated roundtable last July that he “wouldn’t say it’s dead. It might be resting” when asked about the applicability of Phillips’ theory. Prominent economists such as Lawrence Summers of Harvard University argue that the Phillips curve is, in fact, dead.

March’s labor statistics, as reported by the Bureau of Labor Statistics, continue to confirm the so-called death of the Phillips Curve. The unemployment rate was 3.8 percent, which continued a near 10-year consecutive decline, and the inflation rate was reported at 1.9 percent, below the Fed’s target rate of 2 percent. The Fed will have to address this new economic phenomenon of simultaneous low inflation and low unemployment, and uncover what macroeconomic factors are contributing to the diminishing correlation between inflation and unemployment.

The Hutchins Center for Fiscal and Monetary Policy argues that the two primary reasons for this regression are the rise of globalization and decline of worker power. US-based multinational corporations have begun a trend of hiring foreign workers when the domestic labor market is unable to provide supply for labor shortages, compared to Phillips’ assumption that corporations would increase wages to attract American workers, thus explaining the impact of globalization. And in the last few decades, workers have seen diminishing bargaining power with employers, thus leaving wages relatively stagnant.

The pressure on the Federal Reserve, specifically on Chairman Jerome Powell, to figure out its position on interest rates will certainly not let up before the next FOMC meeting on June 18-19.

 

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