Commentary: When will the Fed raise rates?
This article originally appeared in the St. Louis Beacon. - The Senate Banking Committee, in a 14-8 vote, recently sent to the full Senate, President Barack Obama’s nominee to become the next chair of the Federal Reserve Board of Governors. With the change in filibuster rules, Janet Yellen’s confirmation is a near certainty.
Following the Thanksgiving break, the Senate will vote to replace Ben Bernanke with the first woman to lead the Fed. Yellen’s ascent to chair of the Fed is historic. More importantly, her confirmation raises a serious policy question: Will she give too much weight to achieving low unemployment rates and ignore the other side of the Fed’s policy coin, which is to maintain low rates of inflation?
The conditions that arose in 2008 — the seizing-up of financial markets, the near-collapse of the economy and the spike in unemployment brought forth significant intervention by the Fed. Under Bernanke’s leadership, the Fed actively pushed short-term interest rates to their lowest level in memory. The interest rate used to assess policy actions, the federal funds rate, has hovered near zero since December 2008.
The Fed achieved such a historically low interest rate through a program of massive purchases of various financial assets from financial institutions. Under its current “quantitative easing” (or QE) program, the Fed purchases $85 billion in Treasury and mortgage-backed securities each month.
While interest rates dropped, banks responded by holding ever-increasing amounts of reserves. Excess reserves, those held over and above required levels, swelled to unimaginable heights. Excess reserves today are approximately $2.3 trillion, compared with a mere $1.5 billion in late 2007. And they continue to grow. Since last year excess reserves have increased more than 60 percent.
These funds the Fed is injecting into the banking system are sitting idle. Economist Christopher Neely of the St. Louis Fed wrote earlier this year that while “the intent of QE was to encourage interest-sensitive spending and investment spending” it did not “dramatically increase bank loans and the growth of the broader monetary aggregates.”
In other words, a policy of keeping rates low, one fully endorsed by the presumptive chair has not delivered. The increased investment by business, more borrowing by households and additional lending by banks that Fed officials hoped would spur economic growth and lower unemployment have not materialized.
Since Yellen advocates continuation of current Fed policy until the unemployment rate declines substantially from its current level of 7.3 percent, the direction she will push Fed policy is problematic.
A policy of continued expansion until the unemployment rate is “low enough” begs the question of what an acceptable rate. Without that, uncertainty over policy will arise. Some have suggested that the Fed wean itself from its QE program when the unemployment rate reaches 6.5 percent. Others argue for an even lower target of 6 percent unemployment. If it must reach the level considered to be the “full employment” rate, just what might that be?
Watching the unemployment rate as the needle in the gauge of policy action is fraught with risk. For one, the unemployment rate is poorly measured. The discouraged worker effect — workers unable to find employment simply drop out of the labor force — has well-known effects on the measured unemployment rate. If the economy improves, for example, those workers will re-enter the labor force and in all likelihood the unemployed rate will tick up. That would erroneously call for more aggressive Fed actions.
Along with the new chair, President Obama has the opportunity to fill several more vacancies on the Board of Governors. Under the new rules governing the Senate, he is prone to appoint individuals with similar views to the new chair. That will signal a drift in Fed policy to one that focuses more on actively pursuing lower rates of unemployment.
The real question is whether the new board under Chairwoman Yellen will have the fortitude to raise interest rates if the rate of inflation begins to rise and unemployment targets have not been achieved.
Rik Hafer is a distinguished research professor in the Department of Economics and Finance at Southern Illinois University Edwardsville and a scholar at the Show-Me Institute.