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Blinder Leading The Blind

Authored by Alan Blinder via WSJ Op-Ed,

The Fed Can Be Patient About Raising Interest Rates

As the Federal Reserve’s Open Market Committee prepared to meet last month, no one was wondering what the Fed would do. Everyone knew it would do nothing. There would be no rate hikes, no balance sheet shrinkage, nothing.

Instead, financial eyes were glued to what it would say. In particular, would the FOMC continue to characterize itself as “patient” about raising interest rates? Or would the word “patient” be dropped, sounding alarms of higher rates to come?

On Wednesday, March 18, the financial world got its answer: The Fed is still patient, in fact extremely patient. But it’s not going to use that p-word anymore. Instead its language is now more specific. “The Committee anticipates that it will be appropriate to raise the . . . federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective.”

The most important word in this sentence got little attention: and. The Fed wants to see two things before it is ready to raise interest rates: “further improvement in the labor market” (even though the unemployment rate is now back to spring 2008 levels), and convincing evidence that inflation (which has been running below target) is heading back to 2%. Waiting for both may require a lot of—well—patience.

Then why jettison the p-word? As devout Fed-watchers know, Chair Janet Yellen had defined being “patient” as waiting at least two more Fed meetings—roughly a quarter—before raising rates. She said “at least two,” but markets, craving concreteness, translated that to exactly two. So dropping “patient” in March would have been read as a signal that a rate hike was likely in June. The Fed did not want to send such a signal. So the p-word disappeared even though the p-concept remained.

How patient will the Fed be? Its latest forecast sees the unemployment rate dropping into its target range, now 5%-5.2%, by the fourth quarter. But the Fed keeps lowering that target range. And inflation is not forecast to reach 2% until 2017.

Are Yellen & Co. right or wrong to be so patient? I think they are right. Consider:

The so-called hawks, who have been calling for rate hikes since 2009, have constantly warned of high inflation lurking just down the road. It must be a long road. The Fed’s favorite measure of core inflation (which omits food and energy prices) has been stuck in a narrow range between 1.3% and 1.7% since mid-2012. Headline inflation, which includes food and energy prices, is roughly zero. If the rationale for interest-rate hikes is heading off inflation, this performance practically cries out for patience.

Most economists believe it is hard to sustain higher inflation unless wage increases, which have been flat for several years, also speed up. The impatience lobby is now seeing a glimmer of wage acceleration—for, say, the last quarter or two. But it’s just a glimmer: Wages now are rising about 2%-2.5% a year instead of 1.5%-2%. With even very modest growth in labor productivity, wage increases that low are consistent with price inflation below 2%. A Fed that wants to be “reasonably confident” that inflation is rising toward 2% needs to be patient.

A tight labor market could push up wages faster. Hawks look at today’s unemployment rate, which is 5.5% and falling, and see a labor market that is already tight and getting tighter. Ms. Yellen and the FOMC majority disagree. They patiently await “further improvement in the labor market”—meaning, among other things, unemployment below 5.2%. The many Americans who have been jobless for a long time are waiting with them.

Besides, the economy hit a speed bump this winter; indications are that the first quarter was very weak. And the appreciation of the dollar bodes ill for U.S. exports.

The impatience crowd once worried loudly and frequently about a different set of problems. Specifically, that near-zero interest rates and/or quantitative easing were allegedly causing financial-market “distortions” and “bubbles.” Distortions threaten the efficiency of the vaunted financial system. Bubbles might burst, causing untold damage to our economy.

Let’s see. The federal-funds rate has been near zero for over six years now, and the Fed’s balance sheet is roughly five times as large as when Lehman Brothers failed. Yet none of the hypothesized financial hazards have surfaced. So you don’t hear the scare stories much anymore. Here, too, the evidence suggests that patience is the right policy.

To be sure, the Federal Reserve will not maintain near-zero interest rates and a $4.5 trillion balance sheet forever. Monetary policy will eventually begin to normalize. But not in June, and maybe not in September. Timing, they say, is everything. This is a time for patience.