Skip to content Skip to footer
|

The Case Against Raising Rates Too Early

“I find it very hard to understand why anyone thinks rates should rise even in 2015.”

Right after the most recent jobs report was released showing that things were better than expected, my inbox started to fill up with demands that the Federal Reserve accelerate the pace of “normalization” and predictions that it would do so soon. But the case for wait-and-see actually remains as strong as ever, and maybe even a bit stronger.

There are, as I’ve tried to explain before, two key points for Fed policy. The first is that we don’t know how much slack there is in the American labor market. The second is that the consequences of overestimating slack and waiting too long to raise interest rates would be relatively minor, while the costs of underestimating slack and hiking rates too soon could be immense.

On the first point: We really don’t know how much slack there is. Don’t show me your new estimation method and claim that it proves that “there is x percent of slack.” There are lots of clever people out there doing clever estimates; they don’t agree, and nobody really believes in econometrics anyway unless the numbers tell them what they want to hear. (Sorry, but that’s reality.) We really won’t know much about slack until after the fact, if and when we finally see a notable pickup in inflation, and in particular in wages.

On the second point: If the Fed waits too long, inflation might pick up for a while, and getting it back down to target would hurt (although the target really should be higher). But that’s minor compared with the alternative scenario of raising rates too soon and then finding that we’ve entered a deflationary trap that’s really, really hard to get out of. If you’re at the Fed, would you rather wake up and discover that the core inflation rate has risen to 3 percent or that you’ve become European Central Bank President Mario Draghi?

And if you’re puzzled that a falling unemployment rate hasn’t translated into faster wage growth, well, that just reinforces the point that we truly don’t know how much slack there is.

Does anyone think that wage growth was wildly excessive before the 2008 financial crisis? If you don’t, then you should believe that we need an extended period of tight labor markets just to get back to where we were.

There is nothing in the new jobs report to suggest that it makes sense to hike rates any time soon.

In fact, I find it very hard to understand why anyone thinks rates should rise even in 2015.

Punished for the Dollar’s Virtue?

I rarely disagree with the economist Jared Bernstein, and I actually agree with most of a recent blog post he wrote earlier this month connecting full employment, trade deficits and the dollar as reserve currency (bit.ly/10QUHI7). Yes, I agree that the persistent trade deficit in the United States is a problem for achieving full employment, and that we should have a weak-dollar, not a strong-dollar, policy.

But is the dollar’s reserve-currency status the root of the problem? I have long argued that reserve-currency status is an overrated phenomenon – it’s not actually a significant benefit to the country that issues the currency, even aside from the employment issues. But I’m also not convinced that it’s that big of a deal when we try to understand persistent trade deficits. After all, we’re not the only country that has run long-term external deficits.

We do have things that cause a global savings glut to spill into the United States – a big, deep financial market (with lots of players willing to create what look like safe assets) along with a general sense that America is the refuge of last resort, and so on. But Britain offers many of the same things, and has, in fact, a comparable record of persistent capital inflows and deficits, while Australia has run really big external deficits for a very long time.

As a policy issue, I don’t think this matters too much – we should seek a weaker dollar.

But I don’t think phrasing the problem in terms of the reserve-currency status is helpful.