The Interest Rate Policy Pickle

Looks like we’re in a bit of a pickle in terms of setting interest rate policy. Janet Yellen, the current Fed Chair for those who don’t know, recently testified in the face of a new IMF paper that indicated a structural change in global economies may be taking place.

To back up a step, the Federal Reserve is mandated with achieving a balance between economic growth (measured in real GDP growth) and inflation (measured by growth in the Consumer Price Index, or CPI, excluding food and energy). Typically, the Fed has a 2% inflation target meaning that if inflation is under 2%, the Fed will err on being accommodating and try to keep interest rates lower to help the economy grow and spur inflation. On the other hand, if inflation is over 2%, the Fed will err on being restrictive to try to keep inflation from spiraling out of control (as it did from 1980–1983, the last time the Fed had to manage spiraling-out-of-control inflation). Currently, inflation is well under 2% despite growth coming back in line with an expanding economy and despite a tight labor market.

Traditionally, the Fed looks at a number of key indicators to determine what is going on in the economy; however, right now, we are in the midst of a strange situation where some indicators are leaning one way, while others, and the inflation data, seem to be going the other way. As a result, the picture doesn’t align with the “traditional” approach to setting interest rate policy.

Unemployment, capacity utilization, real GDP growth, and wage growth, among others, are key factors that help drive the Fed’s interest rate decisions. The IMF warned today in a new paper that central banks should keep an eye on wage growth specifically because that indicator has been sluggish. The graph from the Wall Street Journal’s article about the IMF paper is provided here:

Now, if wage growth is simply sluggish due to transitory factors (such global weather, or some unexplained lag in wage growth responding to a lower unemployment rate), then the Fed is right to keep on raising rates. But if slow wage growth is a result of a change in how global economies work, then the Fed should be a bit more wary than normal and look to keep rates lower than they normally would at this point in the cycle.

The article provided one example of what such a structural change might look like: Involuntary Part Time workers. Below is the graph of these workers broken down by global economies’ percentiles. We can see that overall, there are far more involuntary part time workers than before the recession started in 2007.

This change, which is most readily apparent among the 75th-90th+ percentiles, could mean that our traditional understanding of how low unemployment leads to wage growth is about to, or already has, broken down.

Some other factors might be spending on health care, which represents 8% of consumer expenditures. The 2010 health-care law, according to Yellen, might be slowing down health care inflation. Further, U.S. inflation also could be more closely tied to the global economy, which means weakness abroad or cheaper labor costs in other countries could be holding down domestic prices and wages. And finally, the Fed Chair also cited the possibility that online shopping could be holding down prices, and thus, inflation.

If these factors turn out to be true, the pickle we’re in might just get even picklier, but if the data provide indications one way or another, at least we’ll know what might be going on rather than being where we are, which involves calling the low inflation we see in the U.S. “a mystery” for now.