As America’s Central Bank, the Federal Reserve serves as the decision-making body for U.S. monetary policy, promoting the health and stability of the overall financial system. Through targeted and measured hikes to the benchmark Fed Funds rate, it seeks to balance economic growth and inflation. But this is not without risk. If the Fed raises rates too fast, it risks prematurely stunting economic growth. Too slow, the Fed risks the economy overheating with runaway inflation.
The Fed has been resolute in its proposed rate agenda of three interest rate hikes each year in 2017, 2018 and 2019. It has already raised rates, by 0.25 percent, in March and June. The third, presumably, will be in December.
But economic growth has been lackluster, wages are stagnant and inflation is declining. Hardly the ideal environment for a coordinated series of rate hikes. Inherently, rate hikes reduce demand for goods and services and restrict economic growth. They increase borrowing costs to consumers and businesses and act as a greater incentive for saving, not spending. Given the current economic environment, why is the Fed so adamant about the need for continued rate hikes?
To answer, we can look to the strength in the American labor market.
Employment data, released each month by the U.S. Department of Labor, remains strong. In July, employers added 209,000 non-farm jobs to their payrolls, well above the consensus estimate of 178,000. Year-to-date, the American economy has added an average of over 184,000 jobs each month, equaling the robust pace of 2016. The national unemployment rate declined in July to 4.3 percent, matching a 16-year low. The Fed projects a sustainable unemployment rate of 4.3 percent in 2017 and of 4.2 percent in 2018 and 2019.
The Fed believes, at some point, strength in the labor market will eventually trigger inflation, higher wages and greater economic growth. It argues the weakness in inflation is transient, that a tightening labor market will eventually force employers to raise wages to attract quality workers. As wages rise, so should consumer demand for goods and services, driving higher prices, increased production and corporate profits.
For now, it seems, the Fed’s gamble has not paid off. Despite years of stellar job growth, inflation remains well below the Fed’s target rate of 2.0 percent. In fact, inflation hasn’t reached 2.0 percent since April 2012. The latest core Personal Consumption Expenditures Index, or PCE, indicates inflation has only increased by 1.5 percent year-over-year. Core PCE, the Fed’s preferred method of tracking inflation, measures the annualized change in prices paid by consumer households for goods and services, excluding the more volatile and seasonal food and energy prices. Since January, inflation has been in a downward spiral, averaging 1.65 percent. In June, the Fed was reluctantly forced to lower its inflation projections for the remainder of the year to just 1.7 percent.
Moreover, wage growth remains stagnant. Since 2015, annual wage growth has averaged just 2.48 percent, well below the 3.5-4.0 percent growth typically seen with unemployment this low. Thus, it was no great surprise when the year-over-year wage growth for July was reported at 2.5 percent.
Ultimately, it is increasingly difficult for the Fed to explain away the lack of inflation. The proposed December rate hike is looming. Also, at its September meeting, the Fed is expected to announce its plans to wind down its massive $4.5 trillion balance sheet later this year. Simply stated, in a process known as “tapering”, the Fed will gradually reduce the volume of government debt and mortgage-backed securities it bought in response to the 2007-2009 recession. The designed purpose was to artificially stimulate economic growth in response to a then struggling U.S. economy. Unfortunately, tapering has a constrictive effect on economic growth, as it increases long-term borrowing costs.
Armed with a robust labor market, the Fed appears ready to double-down on its assertion that weak inflation is still transitory and that rising prices and wage growth are right around the corner. Within the next few months, the Fed is faced with two key issues: the third planned rate hike, and the tapering of its balance sheet. Unfortunately, both may further reduce inflationary pressures. Yes, the economy continues to chug along at a moderate pace. But the Fed doesn’t have much room to maneuver if the economy suddenly heads south. We can only hope its gamble pays off.