Fed Chairman Powell will keep rates low — he has no choice

Fed Chairman Powell will keep rates low — he has no choice
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The Federal Reserve Board members and the Fed’s newly nominated chairman, Jerome Powell, have no choice but to continue to effect relatively low interest rates, even as they continue to gradually tighten the federal funds rate to prop a slow-growth economy. It is their Hobson’s choice of no choice at all.

This is because the inflation-unemployment tradeoff, known as the Phillips Curve, ceased to be an effective monetary policy framework and because the pains of the Great Recession are still fresh in the minds of board members, including Powell, who has been on the Fed board since 2012. This policy stance will delight Wall Street, investors of all types and propel more savers into the stock market.

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The Phillips Curve reflects an inverse trade off between changes in the rate of unemployment and the rate of change in wages (i.e., inflation), based on data from the United Kingdom’s economy in 1861-1957. First published in Economica in 1958 by A.W. Phillips, the Phillips Curve became the conventional wisdom, guiding the monetary policies of the world’s developed economies.

 

This happened despite Phillips’ own warning that “these conclusions are of course tentative.” Phillips’ own analyses of some the sub-periods of his 1861-1957 data showed very weak tradeoffs and reflected drastic changes from an agrarian to an industrial society, as well as two World Wars.

More recent data from the U.S. Bureau of Labor Statistics show that between June 2009, when the Great Recession ended, and September 2017, the unemployment rate fell from 9.5 percent to 4.2 percent, but inflation went up from about zero to only 2.2 percent.

This means that there are now over 8.21 million previously unemployed people, spending money and increasing demand for goods and services, yet their demand surge raised inflation to only 2.2 percent. According to this tradeoff, every 3.7 million new jobs increases inflation rate by 1 percent.

In other words, 3.7 million additional jobs will have to be created to increase the inflation rate from the present 2.2 percent to 3.2 percent to motivate the Fed to raise the funds rate much more aggressively. This is very unlikely to happen, because increasing employment by that much is rather impossible in the short term.

Moreover, the Phillips Curve can lead to harmful monetary policy decisions. In the 1970s, many countries, including the U.S., experienced inflation and unemployment simultaneously, rather than inversely, as the Phillips Curve maintained. Paul Volcker, the chairman of the Fed then, raised the federal funds rate to crush inflation, which produced the 1981-1982 recession. 

Now, the Fed and its newly nominated chairman, Jerome Powell, are puzzled by the inflation-unemployment relationship. In this environment, the Fed and many central banks in Europe and Asia have no choice but to tread lightly and be careful not to tip the economic boat into another recession.

Like a good doctor, the Fed has been cognizant to “do no harm” and has resorted to make decisions using ad-hoc data on employment, inflation, manufacturing and retail sales, to name but a few. Knowing that these data have no magic remedies, the Fed, like a doctor prescribing an experimental drug, has been very cautious in its policy measures, bent to err on the accommodating side.

So far, the Fed, with Janet Yellen as its chairwoman and Powell as one of its members, has done a remarkable job keeping the patient alive and reasonably healthy. It has kept the federal funds rate relatively low, even as it has been raising rates.

Even with two more quarter-percent rate hikes anticipated — one in December 2017 and another in 2018 — the real interest rate, i.e., the nominal interest rate minus inflation, will continue to be close to zero.

As a result, demand for all assets, from stocks to real estate, will continue to be firm, which in turn, could bring additional economic growth. This "steady-as-she-goes" pace could last as long as the developed economies in Europe and Asia continue to be relatively weak, keeping the lid on U.S. inflation and as long as other internal and external factors do not derail the economy. 

As a member of the board since 2012, Powell has helped set this path. When confirmed, he and his board will continue to implement this stance — they have no choice. 

Mr. Powell, meet Mr. Hobson. 

Avraham Shama is professor of international management at The Anderson School of Management at the University of New Mexico. His book, "Marketing in a Slow-Growth Economy: The Impact of Stagflation On Consumer Psychology," was published by Praeger in 1980.