Eric Rosengren, the President of the Boston Federal Reserve Bank, was one of three dissenting votes in the Fed's decision last week not to raise the benchmark interest rate they control. Since Rosengren has a pretty dovish record—he's not one to see spiraling inflation around every corner, when the data say otherwise—his dissent was surprising and interesting.
Perhaps for that reason, he took the somewhat unusual step of explaining his vote in a noteposted on the Boston Fed's website. I've pasted in excerpts of his explanation (in italics), followed by my own annotations. I didn't want to pass up this opportunity to argue with a thoughtful guy about a big decision.
ER: Since the most recent increase in the target for the federal funds rate last December, the economy has made further progress toward achieving the Federal Reserve's dual mandate (maximum sustainable employment and stable prices). The labor market continued to improve as the U.S. economy added over 1.4 million jobs so far this year. Given these improvements in labor markets, wages have risen gradually – wage growth is now above the roughly 2 percent level that it seemed stubbornly "stuck" at, earlier. The growth rate of core PCE inflation has risen modestly, to 1.6 percent.
JB: All true, but let me add some color. First, ER leaves out a very important point here: the Fed's "stable price" target is 2 percent, and they've missed that on the downside every single month for four years running. Moreover, the metric he cites has come in at 1.6 percent every month this year except one when it was 1.7 percent. In other words, no sign at all of acceleration, even as the job market has tightened and, as ER correctly notes, wage growth has picked up a bit.
But Fed officials must worry not just about actual inflation, but inflationary expectations, right? Well, according to the Cleveland Fed, "[Our] latest estimate of 10-year expected inflation is 1.72 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade."
As far as employment's concerned, ER's right again that jobs are up about 1.4 million so far this year, an annualized growth rate of 1.5 percent. But last year at this time they were up 1.7 million, an annual growth rate of 1.9 percent. Again, no acceleration.
In other words, hard to see what there is in the data ER cites that would explain his dissent.
ER: This progress has occurred despite significant headwinds from abroad, including a slowdown in China's economy, a surprising "Brexit" vote, and continued problems in some European banking organizations.
JB: True dat. We've got a highly resilient economy (though our exposure to Brexit was never much, and while it's still early–the UK is still in the EU–predictions of a Brexit slump for the UK have not come to pass).
But the relevant question here is: how does slower growth abroad feed into monetary policy? With low interest rates everywhere else, even a small rise in Fed's rate can pull in capital from abroad seeking safe-haven in dollar-denominated investments. This further strengthens the dollar, which in turn pushes back on inflation (more target missing) and boosts the trade deficit. The key point is that an unwarranted rate hike can serve as a conduit through which weaknesses abroad can enter the U.S. economy.
ER: The economic progress since the last tightening in December might, by itself, be sufficient to justify a further increase in the rate target. However, it is in considering the implications of current policy for the sustainabilityof the expansion that the case for raising rates has now become even more compelling.
JB: OK, this is the first thing he says that completely loses me: "We raised rates a little and things look basically fine, so hey, let's keep going." I get that this is just a short note which leaves out a lot of ER's thinking, but that's just not analysis. Surely, in the age of Yellen and a data-driven Fed, what's "sufficient to justify a further increase" must be some evidence of pressure building, of overheating. This is especially germane when you consider that the recovery is just now beginning to reach middle- and low-income families who've heretofore been left behind. (FTR, last time I visited the Boston Fed, I learned about somegreat projects that Rosengren and his staff were running in less advantaged communities, so this inequality problem is well known to him.)
ER: Federal Reserve staff forecasts, like those of the bulk of private forecasters, see the labor market tightening considerably over the next three years – and this is the case even assuming more rate increases than are currently anticipated by market participants and reflected in market rates. By 2019, I expect the unemployment rate to have declined below 4.5 percent. While I have a long track record of advocating for policy that supports robust labor market conditions, that is below the rate that I believe is sustainable in the long run.
JB: It's been widely observed that the vast majority of forecasts, especially for GDP and interest rates, have been too optimistic is recent years (see figure here for an example of what I'm talking about). But put that aside, as it's a good bet that the labor market continues to tighten (especially if the Fed keeps their feet off the brakes!).
Where ER goes seriously wrong here, at least IMHO (and he's got a big staff a big brains behind him, so I'm willing to be corrected), is in his confidence that he can identify the "natural rate" of unemployment: the lowest unemployment rate consistent with stable prices.
As I show here, citing work by President Obama's CEA, these days the confidence interval, or margin-of-error, around natural rate estimates run from around zero to about 6 percent.Earlier work from top macro-statisticians identified a similar problem, and that work was done before the decline in correlation between unemployment and inflation (the model from which the natural rate calculation derives), which further widens the confidence interval.
ER's claim about his advocacy record is true and admirable, but I'd strongly urge more humility here about economists' ability to accurately predict the impact of falling unemployment on inflation. No question, there's evidence that this relationship is alive and well, but given the uncertainty, the responsible analytic position right now is to be far more data driven than model driven. Such caution is especially warranted given the asymmetric risk scenario recently outlined by Fed governor Lael Brainard (the risks of weaker demand are greater than those of accelerating price growth).
ER: Unemployment this low may well have the desirable effect of bringing more workers into the labor force – but, unfortunately, only temporarily. Historical experience suggests it also risks overheating the economy, the effects of which include heightened pressure on inflation and potentially increasing financial-market imbalances.
JB: No, it doesn't, at least not always ("historical experience suggests…"). I was paying close attention back in the 1990s, when many economists believed the "natural rate" was 6 percent. Chairman Greenspan, to his credit, thought otherwise, and as the rate fell to 5 and then 4 percent, he convinced the committee to hold their fire. The benefits of the 1990s expansion finally began to show up big-time in the real wages and incomes of low- and middle-income families, and here's the kicker: inflation did not, I repeat, did not, accelerate anything like the models predicted it would.
Granted, key to these dynamics was Greenspan's recognition that the 1990s acceleration in productivity growth could pay for non-inflationary wage gains (i.e., stable unit labor costs). Today, productivity growth is worryingly slow. But it's also the case that recent research shows little evidence of wage growth bleeding into price growth, so again, uncertainty, in tandem with the data on actual and expected inflation, should yield caution.
Finally, ER writes:
My goal is to achieve a long and durable recovery – a sustainable expansion. For the reasons articulated above, I believe a significant overshoot of the full employment level could shorten, rather than lengthen, the duration of this recovery.
JB: I'm totally with you, dude, and for all my critiques, you may be right and I may be wrong. Also, a small brake-tap (a 25 basis point rate hike) is not likely to do a lot of harm to the macroeconomy, though its impact is amplified among the least advantaged (e.g., black unemployment takes a disproportionate hit).
Still, the unfortunate, though interesting, truth is that we are at a point wherein our understanding of critical, basic macroeconomic relationships—the unemployment/inflation tradeoff, the natural rate of unemployment, wage/price dynamics, the neutral rate of interest, the best target for monetary policy—is uniquely weak. Combine that reality with the benefits of growth are just now reaching lower and middle-income households, and, along with the facts I muster above, you get my argument for erring on the side of caution.