Holding off on rate hike shows Yellen deserves reappointment

After three increases since December 2016, the Federal Open Market Committee (FOMC) of the Federal Reserve announced today that it is holding rates steady. This is the right move, and it lets those of us hoping the Fed would follow evidence-based rules when making policy breathe a sigh of relief.

The background to today’s decision is straightforward. When setting interest rates, the Fed is bound by law to maximize job growth, so long as this does not lead to accelerating inflation.

{mosads}When the economy is weak and needs a boost, the Fed cuts interest rates to make it easier for businesses and households to borrow money to finance new spending. When the economy is going too fast and the Fed decides that inflation is starting to accelerate, they raise rates to reduce borrowing and spending. 

The key link in the chain between fast economic growth and potential inflation is wages. As rapid job growth leads to lower unemployment, this boosts workers’ leverage when negotiating with employers over pay.

It’s no coincidence, for example, that wage growth was much better in 2015 and 2016 than in the years before when unemployment was substantially higher. If unemployment gets low enough, the fear is that workers’ leverage will lead to wage increases in excess of employers’ ability to pay without starting to raise prices.

If the economy continues to run hot, then a wage-price spiral that sees pay raises and price increases chase each other ever-upward is the concern.

Since they have raised rates three times in the past eight months before Wednesday’s meeting, one might think that the Fed had seen data on wage and price growth that made them think that the economy was about to blow right through their 2-percent inflation target. But they haven’t.

Price inflation has actually run below this target almost every single month for the past five years. The first half of 2017 saw pretty steady declines in inflation. Wage growth has similarly shown no durable acceleration and remains weak enough to actually pull down price inflation over the long run.

Why, then, did the Fed raise rates over the past eight months? In my view, they simply made a mistake. They were fighting potential inflation that might be lurking around the corner rather than any real-world inflation in front of us.

Trying to stay “ahead of the curve” on inflation has real consequences; if the Fed decides that unemployment cannot settle below, for example, 4.5 percent in the long run, they will raise rates to make sure this doesn’t happen.

But if they’re wrong, and 4-percent unemployment would also keep inflation steady, this translates into about a million potential workers not having jobs. The labor market softness caused by holding unemployment higher than it needs to be to fight inflation will undercut workers’ ability to get higher wages.

The last time we saw strong, sustained growth up and down the pay scale, it was during a period when the unemployment rate averaged 4.1 percent for two straight years, with several months where it actually fell below 4 percent.

Today’s rate is a welcome course correction back to letting data, not speculation, determine the pace of rate increases and letting the economy test the lower limits of unemployment that can be reached without setting off inflation. Following this more pragmatic course can yield large benefits.

This course correction is also why our recommendation that Janet Yellen be reappointed as chair of the Federal Reserve still seems solid to us. Yes, we disagreed with the rate increases earlier in 2017, but her overall tenure at the Fed has been marked by genuine recognition of the value of low unemployment to low- and moderate-wage workers and a commitment to letting data guide decisions.

The Fed’s leadership and decisionmaking has profound consequences for working Americans, and the other branches of economic policymaking (most notably the president and Congress) are not showing much good sense.

It would be a great relief to have a responsible, evidence-based decisionmaker like Yellen controlling at least some levers of policy.

Josh Bivens is the director of research at the Economic Policy Institute.