The Fed is slowing the economy in order to save it
For the third time this year, the Federal Reserve voted Wednesday to raise interest rates, the latest move in its effort to keep the US economy from overheating.
The Fed also signaled it’s not through tightening credit. With GDP growth besting expectations, and an unemployment rate nearing 50 year lows, most Fed policy makers expect another economy-slowing rate hike is expect in December, followed by three or possibly four next year.
Collectively, those hikes will mean higher borrowing costs for businesses and consumers.
Behind these moves is an uncertain attempt to buck history and accomplish a feat that few central banks have managed: keeping unemployment low without generating too much inflation.
Look at a graph of the unemployment rate over time and what you see is something like a mountain range or a roller-coaster, with lines moving relentlessly up and down as the US economy collapses and recovers.
What’s missing are the valleys, extended periods when the unemployment rate stays low and stable. The United States hasn’t enjoyed any such moment since 1960s (and those years were marred by fast-rising inflation).
So today’s Fed is operating very much in the dark, without a clear manual for success. But it does have a plan: using a series of deliberate rate hikes to stanch further economic improvements and keep the US economy poised on the near side of that line between strong growth and unsustainable growth.
Wednesday’s hike pushed the federal funds rate above 2 percent for the first time since the financial crisis, setting a target range of 2 to 2.25 percent. The Fed also raised its estimate of 2018 economic growth to 3.1 percent and updated its estimate of the best path for future interest rates, cresting to 3.4 percent before settling back at 3.0 percent.
Each rate hike along that path will have a slight, moderating effect. Enough increases, one after another, can change the whole economic calculus, keeping businesses from expanding even if it means slower hiring and higher jobless rates. For consumers, it will mean higher mortgage rates and higher interest on credit card balances.
Hard as it may be to stomach, sometimes the Fed actually needs to increase unemployment. Otherwise, jobs can become too plentiful, with vastly more openings than qualified candidates. When that happens, business have no choice but to lure workers from other companies with the promise of higher pay — before passing those extra labor costs onto customers in the form of rising prices, a.k.a. inflation.
So at some point, when the economy is smoking hot, the Fed really does have to slow things down or risk spiraling inflation.
Trouble is, no one really knows where that tipping point lies. And in the past, the Fed has regularly leaned in the wrong direction, setting off needless recessions by raising rates prematurely.
One objection to the Fed’s current rate-hiking plans is that inflation remains relatively low. Only in the last few months has the inflation rate approached the Fed’s 2 percent target — not to mention that this target is explicitly “symmetric,” meaning that inflation is supposed to rise above 2 percent just as often as it falls below.
And there are benefits to ultra-low unemployment that the Fed is forgoing by tapping the economic brakes. Faster wage growth is the big one, especially as wages have remained anemic throughout this recovery. But there’s another potential benefit. If wages did start rising, some business might decide forego hiring and invest in labor-replacing machines or robots. That would boost overall productivity, which is the real source of long-term economic health.
But such arguments have lost traction at the Fed. All that remains of the anti-rate-hike wing is a lone voter who thinks rates should stay right where they are, and President Trump, who has said he’s “not happy” that the planned rate hikes may stem economic growth.
The Fed is betting that the secret recipe for balancing low unemployment with low inflation involves steadily rising interest rates. Hopefully they’re right.