Orange may be the new black, but in my world raising the federal funds rate is the new deficit reduction.
Let me explain. I keep bumping into arguments about why, despite pressures from wages or prices, either in real life or in expectations, the Fed should pre-emptively raise the interest rate it controls in order to stave off future inflation. There’s this, from the NYT the other day, quoting the president of the Atlanta Fed:
“We are going to conceivably have to make a judgment that the outlook, even in the absence of realtime inflation readings that are rising, that inflation is nonetheless converging to target.”
Which I think is a convoluted way of saying, “I don’t care if it’s not in the data. Let’s just raise the damn rate already!”
Then I read this Goldman Sachs research note this morning (no link). Their stuff is usually very sensible but this one was a head scratcher. It started out from the important observation, one I’ve been struck by as well, that interest rates on longer-term government debt continue to tumble to historic lows (see figure). But then it went as follows:
“If long-term yields are low due to a diminished inflation outlook, Fed officials delay the first hike of the funds rate in our simulation. But if long-term yields are primarily low due to a reduced term premium–for example, because of QE expectations in Europe–Fed officials respond with a more aggressive normalization of the funds rate in our analysis.”
I guess they’re just reporting what the simulation models say (and they use the Fed’s macro model) but does this make sense? Not the “diminished inflation outlook” part, of course, but the term premium part.
A lower term premium just means investors are looking for less insurance against interest rate risk when locking up their dough in longer maturity bonds. And that’s because the future looks weak, especially regarding…wait for it…inflation! Is there some other secret message in embedded in low Treasury yields that should paradoxically nudge the Fed to liftoff sooner than later? If so, I don’t see it (the GS folks have something in there about European QE, but I don’t find that convincing). I see falling Treasury yields reflecting the safe haven of the US economy, along with the weak outlook for inflation here and elsewhere.
I don’t mean to be fetishistic about this—I don’t imagine that a 15 or 25 basis point increase in the funds rate in the second half of the year will be a huge deal, especially with everyone seeing it coming. But why go there? What’s the substantive rationale? The risks here remain as asymmetric as ever: a pre-emptive rate hike that slowed growth and jobs and paychecks poses far more danger than the inflationary risks engendered by a hike that came too late.
I was chatting about that “why” question with EPI research director Josh Bivens this morning and he said, “the Fed’s interest rate increase is the new deficit reduction. Everyone just knows it needs to happen.”
It’s an awfully apt analogy, if you ask me. For years, even when the evidence of pre-emptive fiscal contraction, aka austerity, was known to be clearly negative, serious people insisted that deficits had to come down. Now many of those same finger-waggers just feel it in their bones: the Fed needs to liftoff. “It’s bad enough they’re getting social insurance; now they want a wage increase!”
To be clear, there’s of course a time for deficit reduction and a time for raising the funds rate. But even with the recent progress on the jobs front, we remain some distance from full employment—just look at the wage and price data shown here.
Our deficit scolds are morphing into Fed scolds. So be it. The proper response is the same as it ever was: to ignore them.