On Wednesday, as expected, the Federal Reserve raised short-term
interest rates by a quarter of a percentage point, to 1.25 per cent.
This is still a very low rate by historical standards, but some real
news came during the press conference that the Fed Chair, Janet Yellen, gave to discuss the move. Since replacing Ben Bernanke, in 2013, Yellen
has often tried to explain—in (relatively) plain English—why the Fed
acts as it does. And, when the economy has behaved in ways that she and
her colleagues didn’t anticipate, she has usually acknowledged it and sought
to account for it.
On Wednesday, Yellen did this again. First, she
conceded that the Fed isn’t really sure why, despite a sharp fall in the
rate of unemployment, the rate of consumer-price inflation is lagging
behind the Fed’s target rate of two per cent. But she also insisted that
inflation was likely to pick up in the months ahead, which would justify
the Fed’s interest-rate policy.
To understand the import of these statements, a bit of background might
help. Like most mainstream economists, Yellen believes that there is a
causal relationship between the jobless rate and the rate of inflation.
When unemployment falls below a certain level, the scarcity of workers
enables them to negotiate higher wages, and inflation picks up.
Economists call this threshold the Non-Accelerating Inflation Rate of
Unemployment, or “NAIRU,” for short.
If you are running the Federal Reserve, a clear understanding of the
NAIRU is obviously a very useful thing to have. For the sake of
argument, let’s say that you think the NAIRU is five per cent. If the
monthly unemployment rate then dips below that—to 4.8 per cent, say—you
would expect inflation to pick up in the coming months. And that might
well prompt you to start raising interest rates to prevent an
inflationary spiral from developing.
As it happens, the Fed did once think that the NAIRU was somewhere close
to five per cent. Today, though, the harsh truth is the Fed doesn’t know
what the figure is, or whether it even exists in a usable form. As the
jobless rate dropped from 5.3 per cent, last May, to 4.8 per cent, in
January, the inflation rate picked up a bit, which was consistent with a
NAIRU in the range of five per cent. But, in the past few months, as the
unemployment rate has fallen all the way to 4.3 per cent, the so-called
“core” rate of inflation, which excludes volatile items like energy
prices, hasn’t risen further, as the theory would predict. Instead, it
has fallen from 2.3 per cent to 1.7 per cent. That suggests that the
NAIRU might well be much lower than five per cent, and it raises the
question of why the Fed is still raising interest rates.
Yellen tried to provide an answer. She said
that monetary policy isn’t on “a pre-set course,” and added that the Fed
had “taken note of the fact there have been several weak readings,
particularly on core inflation.” But she also said that, with the
economy creating about a hundred and sixty thousand new jobs every
month, which is probably enough to reduce the unemployment rate even
further, “the conditions are in place for inflation to move up.”
One of the reporters present expressed skepticism about this argument. Howard Schneider, of Reuters,
arguing that the NAIRU could be as low as 3.8 per cent, asked Yellen why
she was rushing to raise rates. She didn’t dodge the question. Referring
to estimates of the NAIRU—the Fed has now reduced its own to 4.6 per
cent—she said to Schneider, “I agree with your assessment there, we are
really not certain what they are.” She went on to say that, rather than
relying on “some preconceived notions,” by which she presumably meant
any firm belief in what the NAIRU is, she and her colleagues were
keeping a close eye on actual developments in the economy.
Yellen also argued, as she has done since the Fed started raising
interest rates at the end of 2015, that the central bank’s policymakers
were simply following the prudent path. In gradually removing some of
the highly stimulative policies that it introduced during and after the
Great Recession, she explained, the Fed was trying to avoid a situation
“where we have done nothing and then need to raise the funds rate so
rapidly that we risk a recession.”
That is a perfectly defensible argument, and many economists still
believe that the Fed has got things broadly right. But, with inflation
having undershot its target for five years now, Yellen and her
colleagues are vulnerable to the charge that they are still playing by
the old rules and reacting to a nonexistent, or very minor, threat.
They are betting that, over the summer months, the economy will recover
from its recent soft patch, and that inflation will resume its upward
path. If this doesn’t happen, though, Yellen will find herself with more
explaining to do.