With the economy humming, you can expect the Fed to hike rates

With the economy humming, you can expect the Fed to hike rates
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After a decade of crisis and slow recovery, the U.S. economy is finally humming. At 3.9 percent, unemployment is at its lowest since the halcyon days of 2000. Inflation is right around the 2 percent level that the Fed targets. GDP is growing nicely. What more could a central bank want?

Being the worriers that they are, the Fed’s leadership has made it clear that it intends to raise the main interest rate it targets, the federal funds rate. The thinking is that the current rate of 1.75 percent is giving the economy a stimulus that it no longer needs.

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Keeping the federal funds rate so low could lead the economy to overheat, as tight labor markets lead wages to rise. As good as this sounds, it would also increase inflation, possibly awakening a beast that has proven very difficult to tame in the past.

 

Additionally, the Fed is concerned that keeping interest rates too low would leave the Fed with too little room to lower rates when the economy next goes into recession. Lowering rates is a far more tested and a more reliable tool to revive the economy than the large-scale bond purchases referred to as “quantitative easing.”

The Fed’s worries about overheating are also fueled by the enormous tax cuts passed by Congress at the end of last year. These cuts will give both business and consumers more money to spend.

Fed Governor Lael Brainard suggested that these cuts could boost the growth of GDP by 0.75 percent — not a small number in our $18 trillion economy. Faster growth could bring forward the point at which inflation reaches uncomfortably high levels.

All this is very clear and has been well-communicated by the Fed. However, there are two notable wild cards in the situation. First, wage growth continues to be surprisingly sluggish with unemployment so low.

While stories about shortages of particular skill categories and professions have been making their way into the media, indicators of either wages or the costs incurred by businesses to employ labor have just not moved that much.

There are many possible explanations, including lower levels of unionization and weakening labor power, the rise of the sharing and gig economies in which full-time work with benefits may be less available and global competition are among the most likely.

Additionally, the deregulatory onslaught of the Republican Congress and president could already be limiting wage increases. At the same time, labor militancy has ticked upward. Teacher strikes are the most outstanding example.

Some have suggested that the lack of strong wage increases should give the Fed room to avoid raising rates very sharply. These voices see room for a degree of “full employment” that we have not seen for a long time, without harmful side effects.

The second wildcard is trade. The discord at the Group of Seven meeting this week brings the controversy over President TrumpDonald John TrumpIran claims it rejected Trump meeting requests 8 times ESPY host jokes Putin was as happy after Trump summit as Ovechkin winning Stanley Cup Russian ambassador: Trump made ‘verbal agreements’ with Putin MORE’s imposition of tariffs to a new level. It is difficult to see where the trade controversy is heading.

In principle, increased tariffs should bump up inflation, as prices of goods subject to tariffs such as steel rise, bumping up prices of goods that use steel and aluminum, such as cars and cans. But increased fear and uncertainty about a trade war could also lead to supply chain disruptions and postponement of investment decisions, lowering output and also inflation.

Despite these wildcards, the Fed has made clear that it intends to continue raising rates in small steps for the time being. The march from a stimulative policy to a neutral policy has been gradual but persistent, and it would be a major surprise if the Fed did not take another step in that direction Wednesday.

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.