After liftoff, Trump-Fed clash could be in the offing in 2017
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In a move that surprised almost no one, the Federal Open Market Committee voted Wednesday to raise interest rates. The target for the Federal Funds Rate will now be between 0.5 and 0.75 percent, a quarter-point increase.

The Fed has been signaling for a few months that it considers economic activity to be fairly healthy. At the post-meeting press conference, Fed Chair Janet YellenJanet Louise YellenTrump puts hopes for Fed revolution on unconventional candidate Fed chief basks in bipartisan praise as lawmakers dismiss Trump attacks New bill will get the labor market running on all cylinders MORE used the words “strong” and “resilient” to describe the economy.

Fed leaders have made clear that they are now more concerned with preventing any incipient inflation pressures than with increasing stimulus to the economy. Even with the new, higher federal funds rate target, interest rates remain at historically low rates.

The Fed sees economic activity as approaching the economy’s safe operating limit. Unemployment reached its lowest point since the Financial Crisis this past month.

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The Fed is very sensitive to signs of strong wage increases that might spill over into rising prices. Past experience has trained the Fed to try to get ahead of inflationary pressures, since containing inflation once it starts to accelerate has proven extremely difficult.

The FOMC statement indicated that the Fed expects to continue raising interest rates gradually. The Fed has been very careful to avoid surprising markets. The Fed had intended to follow-up the December 2015 Federal Funds Rate increase with more increases in 2016, but slow wage growth and continuing below-target inflation, combined with disturbances in global markets such as the sharp setback to China’s equity markets in January 2016, led to postponement. 

Today’s statement indicated some determination to continue raising rates, but no firm commitment as to dates. FOMC members’ projections, which are disclosed to the public, foresee the Federal Fund Rate rising almost a percentage point in 2016. But, as Chairman Yellen emphasized, “policy is not on a pre-set course.” Fed actions will depend on further data.

So far, there are few signs of increasing inflation. The FOMC statement notes that “market-based measures of inflation compensation” (for example, on interest rates Treasury Inflation-Protected Bonds or TIPS) have moved up considerably but are still low. Similarly, surveys of inflation expectations have not moved noticeably in recent months. 

It could be argued that the lack of strong early signs of increasing inflation mean that the Fed could afford to wait to raise interest rates. In a recent blog post, The Economic Policy Institute’s Elise Gould noted that the rate of increase of nominal wages (the dollar amount workers are paid) rose only 2.5 percent in November, below the previous months’ 2.7 percent. She suggests that raising interest rates now would only decrease future wage growth.

Gauging the state of the labor market has been especially difficult since the Great Recession. There has been a big decline in labor force participation, the share of people 16-and-over who either have jobs or are actively looking for work.

However, labor force participation has been falling since 2000, as the baby boomer generation’s gradual move into retirement has raised the proportion of retirees in the adult population. 

Breaking the data down by age helps clarify matters a little, but there are many puzzles. Labor force participation of those people age 50-65 has fallen as well, and it is very difficult to be sure whether these people would like to return to work if they could.

This matters a lot. If many of these older workers would return to work, there might be considerable slack in the labor market. Employers would still have many job applicants to choose from, and wage growth would likely be slow.

This could justify more accommodative Fed policy. If very few of these older workers would return to work, there is very little slack in the labor market. In that case, faster growth would start to raise wages quickly, leading the Fed to raise interest rates to cool the economy off.

Chairman Yellen responded to a question about slack in the labor market in the press conference. She opined that the labor market now has a fairly normal amount of slack, not so different from the situation before the 2008 crisis.

dShe suggested that unemployment is now a little below the “natural” level that would keep inflation stable. In fact, she considers this a good thing, since this low unemployment would tend to push inflation up, moving it up to the Fed’s long-term target of 2% in the coming years.  

The Fed has also expressed some desire to bring the federal funds rate higher in anticipation of any future downturns. They consider it far easier and more effective to stimulate the economy by lowering the federal funds rate than by buying large quantities of bonds, the “unconventional” monetary policy that they have resorted to since 2008.

In addition to this “we have to raise now so we can cut later” argument, the Fed can also point to continued, albeit rather moderate, economic growth since the December 2015 rate hike.

Signals from the incoming Trump administration suggest that it may seek significant tax cuts without offset spending cuts. Some associated with the Trump campaign talked of goals of raising GDP growth to as much as 4 percent.

The Fed, however, has indicated that it considers the growth of potential output to be a little below 2 percent. Once the economy recovers more fully, the growth rate of potential output serves as something of a speed limit for the economy. Clearly, the apparent administration view and the Fed’s view are in conflict.

At this point, it is too early for the Fed to assess the budget policy of the new administration. That will be one of the pieces of “incoming data” they will look at in the months to come. But the specter lurks of an administration dedicated to raising growth through massive tax cuts meeting a Fed determined to raise interest rates to keep inflation contained.

In more normal political circumstances, this would be just another case of the Fed using the independence it has been given by law. Politicians are often eager to improve short-term economic performance, but using monetary policy to pump up the economy has heavy negative consequences when inflation becomes entrenched.

That “political business cycle” is why the Fed was given the independence to make decisions independent of political pressure. But since candidate Trump called out the Fed in rather emphatic terms, there is concern about a confrontation between the two in the next year.

In the press conference, Chairman Yellen took pains to say that “we have time to wait and see” about the budget. She also reiterated the importance of the independence of the Fed, and declined to give advice to the new administration about the budget. For now at least, the Fed is playing its usual role.

 

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.


 

The views expressed by contributors are their own and not the views of The Hill.