Memo to Fed: Let The Economy Overheat

Greg Ip 

        The Federal Reserve signaled Wednesday, with some trepidation, that it remains on track to raise interest rates later this year.
        Ordinarily, with unemployment now approaching levels associated with an economy at full strength, the case for raising rates would be open and shut: the Fed would not want unemployment to drop so far that the economy overheats and inflation takes off.
        But these are not ordinary times. An overheating economy right now would be welcome: It would help nudge inflation back to more normal levels, restore some of the long-term growth potential lost since the financial crisis, and boost ordinary workers' wages more effectively than remedies such as big increase in the minimum wage, which can reduce employment for the low-skilled. While low rates may be fueling speculation in financial markets, that threat doesn't yet outweigh the many benefits.
        Fed Chairwoman Janet Yellen acknowledged the dilemma, noting that moving too early will derail the recovery, while moving too late will cause inflation to overshoot
        There are, of course, risks to keeping rates low. Let's consider them in turn.
        It will raise inflation. This would be a worry if inflation were too high; but it is running at 1.2%, excluding food and energy, according to the Fed's preferred measure, well below its 2% target.
        This is a problem because lower inflation, all else being equal, means lower interest rates, and if the economy heads into the next recession with inflation too low, the Fed might not have enough room to cut interest rates by much. Letting the economy overheat makes it more likely inflation will move back to target, and it would be better to head into the next recession with inflation a bit above 2% instead of below.
        The economy is almost at "full employment," so inflation is about to take off. Job vacancies are the highest on record, signaling emerging shortages of labor. And unemployment is now 5.5%, close to the level usually associated with an economy at full strength.
        However, millions of Americans who are working part time but want full-time work, and others who aren't looking for work but want a job, aren't counted as unemployed. Additionally, structural shifts seem to have weakened workers' ability to win big wage gains. This suggests it may require unemployment below 5% for an extended period to generate significant wage gains and to eventually get inflation higher.
        The economy's supply side has weakened, so there is little "slack" to tamp down price pressure. Both the labor force and productivity are growing at well below prerecession rates, which means that much of the disappointing pace of economic growth is due to a weaker supply-side to the economy. If so, then capacity constraints and cost pressures could emerge more quickly when growth picks up.
        Some of this is due to an aging population and fewer technological breakthroughs, and a hot economy can't solve such structural hurdles.
        Still, a hot economy could reverse some of that damage by drawing some people who had dropped out of the labor force back in. As Ms. Yellen noted, that may already be happening: The labor-force participation rate has stopped falling. It would also reassure businesses that the outlook is buoyant enough to justify more capital spending.
        Easy monetary policy worsens inequality. Low interest rates work in part by boosting the prices of assets such as stocks and property. And since such assets are owned mostly by the rich, this widens the nation's wealth gap.
        But this is a short-sighted objection. Higher asset prices won't make workers poorer; but higher unemployment will. If the economy overheats and unemployment drops below 5%, this will do more for the average worker, with fewer negative side effects, than interventions such as a higher minimum wage. That's the lesson of the 1996 to 2000 boom when the Fed let unemployment fall below 4%. Wages grew strongly.
        Low rates generate financial-market excesses, which could produce a crisis. There is certainly ample evidence that low rates have fueled speculation, such as higher home and stock prices. It would do the Fed little good to keep rates low in hopes of bringing down unemployment only to repeat the crisis of 2008.
        This, however, is not automatically a reason to raise rates. The Fed must weigh the benefits of lower unemployment against the probability and potential severity of a crisis later. A lot has changed since 2008: The reliance on short-term debt and derivatives that made the financial system so fragile is much less evident now, and banks have significantly bolstered their capital buffers to withstand a crisis. If asset prices fall, they are far less likely to generate a crisis.
        Nonetheless, the longer rates stay near zero, the more risk taking will find its way around the rules. So the Fed faces a delicate balance: maximize the benefits of an overheating economy, but minimize the risks of the tools it uses to achieve it. That might mean raising rates this fall, as promised, but being far slower about raising them than even the lowered path officials released Wednesday suggests.
        Write to Greg Ip at greg.ip@wsj.com
        (END) Dow Jones Newswires

        June 17, 2015 19:32 ET (23:32 GMT)

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