Letter to the Fed

July 31st, 2015 at 11:07 am


Dear Chair Yellen,

First, you’re one of my heroes, and not just because of how much I’ve learned from your economic analysis over the years, but also because my daughters are growing up in a world where the world’s chief economist is the same gender they are.

Second, I just don’t get what seems like a real drive from your team to raise interest rates in order to slow the economy. To be more precise, I can see one reason why you might feel compelled to do so, but a lot more reasons why not.

Let me start with the latter:

–Yes, the recovery is trundling along, but not fast enough to create price or wage pressures. One under-appreciated result of this (which I know you and your team know but which I find kind of shocking) is that six years into the recovery, there’s still a gap between actual GDP and potential GDP. Moreover, with yesterday’s downward revision to real GDP growth in the recovery, that gap is a little larger than we thought. Double moreover, as your staff was among the first to show, the prolonged weakness of the recovery is itself partly responsible for the decline in potential. The punchline, from the perspective of Fed policy, is that the current economy is like a slow runner who still hasn’t caught up to a goal line that’s moving closer as she runs towards it.


Source: CBPP. The figure shows potential and actual GDP, in real terms.

Don’t get me wrong. I agree with you that the US macro economy has a lot to show for itself, especially given the misguided fiscal policy thrown at it by the dysfunctional Congress. Especially compared to the other advanced economies out there, our resilience and flexibility is evident. We’ve got liquid financial markets, deep supply chains, and a great Central Bank!

But you well know this recovery has yet to reach all comers, especially the least advantaged among us, and I know for a fact that this deeply concerns you. I just don’t see how raising rates, even a smidgen, helps them. I do see how it hurts them–maybe not a lot given a small bump up in the funds rate, but why go there at all?

–Where are the price and wage pressures? Not only have you missed your 2% inflation target every quarter since 2012q2, but as the figure shows (using revised data on yr/yr PCE core inflation) you’re missing it on the downside by a greater margin over time. What’s again remarkable here is that core inflation has been decelerating while the unemployment rate has been falling sharply, and is now, at 5.3%, within spitting distance of your full employment rate of 5.1%.


Source: BEA

Surely this signals that something fundamental is wrong with a model that’s apparently telling you to raise rates sooner than later.

On the wage side, though there’s always variance, most wage and compensation series have been stuck at around 2% year-over-year growth (nominal) with some, but not much, evidence of acceleration in response to the tightening labor market. The figure below shows our mash-up of four wage series (see data note below the figure), including this morning’s ECI, which came in well below expectations.


Source: First factor from a principal components analysis. Data are yearly changes in four BLS series: production, non-sup wages, weekly median earnings of ft workers, and Employment Cost Index, both compensation and wage components.

Yes, there’s some acceleration toward the end, but surely that’s expected at this stage in the recovery, and at 2%, it’s not inflationary. As you’ve pointed out, your 2% inflation target plus 1.5% trend productivity growth allows for noninflationary nominal wage growth of 3.5%. And here again, I want to strongly emphasize how critical persistent full employment is if we want the benefits of productivity growth to begin to reach middle and lower wage workers.

Chair Yellen, with real growth over the recovery a little slower than we thought, output gaps and job market slack still on the scene, prices appearing to decelerate and wages/compensation revealing little in the way of threatening pressures, try as I might—and I repeat, I’m solidly in your camp—I don’t see the rationale for tightening, even a little. You might of course cite expectations–I know the Fed must try to see around corners–but your own staff models are predicting growth and inflation to proceed in like fashion to the above for the next few years to come. And like most forecasters (including myself), if anything, your predictions have consistently been too optimistic.

Well, OK—if I squint really hard I can see one rationale, but since I haven’t heard your team speak to this, I may well be bending over backwards on your behalf here. There’s another recession out there somewhere and you may well be worried about hitting the zero lower bound again. Thus, you want the fed funds rate to be on a perch high enough such that you have room to come down without hitting zero. This is especially important if you’re worried, as I am and I suspect you are too, that an austerity-smitten Congress will not move fast enough with counter-cyclical fiscal policy.

Neither do I want to overstate my case here. I don’t think a 25 basis point hike in the funds rate, if that’s what you’re contemplating, will make a big difference to the trajectory of any of the variables I’ve cited above.

But it will make a little difference, in the wrong direction, so I still don’t get it and I’m not alone.

Your fan and long-time supporter,

PS: Iced-coffee on me if you want to meet at Starbucks to chat about any of the above!


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One comment in reply to "Letter to the Fed"

  1. Tom_in_MN says:

    I think there is also a similar letter to be written about long term issues. Their problem with the ZLB is exacerbated by low 10 year rates, which they also keep predicting to rise but never do. This ties in with the core PCE plot that hints at heading for deflation. If they want room for short term rates above 0 they will have to get long term rates up and I don’t see any control input other than the inflation target to move them.

    You write the letter and I’ll buy the coffee.

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