The Fed should cut interest rates
Why the conventional economic wisdom is wrong about our current moment
By all accounts, the U.S. economy is booming. At 3.8 percent, unemployment is lower right now than it's been in decades. On Monday, both the S&P 500 and the Nasdaq set all-new record highs.
In the midst of this abundance, allow me to make a seemingly counterintuitive suggestion: The Federal Reserve should cut interest rates.
When I say this is counterintuitive, I'm not kidding. Most mainstream economists regard interest rate cuts as something only done in a crisis, or on the cusp of a recession. Times like right now are when you're supposed to keep rates higher to ward off inflation. Really the only people calling for cuts are President Trump and his advisors, and they're doing it for entirely political and self-serving reasons. Most other observers are deeply skeptical.
Nevertheless, a broken clock can still be right twice a day. Despite no one at the central bank saying so openly, market observers are starting to suspect the Fed may cut rates again in the near future. Reports are also filtering in that Fed officials' thinking may be evolving: They've long feared that monetary policy works on a lag, and inflation needs to be preemptively contained by interest rate hikes. But that fear is dying due to sheer lack of historical evidence, and they may now be willing to hold off hikes until after inflation has already increased.
The actual reasons the Fed should cut rates are twofold: First, dig underneath the numbers, and the economy's a bit weaker than the top-line numbers suggest. Second, the Fed's actually done a lot of damage in recent decades by over-prioritizing inflation. Deliberately trying to overshoot its inflation target now would help repair things.
Let's take those in turn.
At a basic level, economic theory says boom times will inherently lead to more inflation. As real resources in the economy are put to use — especially workers — businesses have to compete more for those resources, bidding prices up. Yet despite the good headline numbers, the Fed's preferred metric of inflation was stuck around 1.6 percent in March and April. That's well below the central bank's self-imposed target of 2 percent, which it has chronically failed to hit for the most of the last decade.
The most likely explanation is that, despite the boom, nominal wage growth for workers — i.e. the price of labor — is still lower than it has been in previous business cycle peaks. There are plenty of likely reasons for this: unions collapsed over the last few business cycles, while monopoly power rose. Meanwhile, labor force participation remains weak compared to previous cycles, which means the headline unemployment rate isn't really capturing how many jobless Americans who want work are still out there.
In other words, poke through the data, and there's a good case we're significantly further than we might think from any real inflationary pressure.
Now about that second point: There's a reason the Fed refers to 2 percent inflation as a "target," rather than a "limit." The idea is that it can overshoot as well as undershoot that target when needed. The central bank's goal of keeping prices low and stable exists in uneasy tension with its other goal of maximizing employment. There needs to be some give and take, allowing the Fed to prioritize one for a while and then the other. Overshooting to 3 or 4 percent inflation would be a perfectly reasonable thing to do if employment and wages need a bit of a boost.
They still need that boost. Over the long haul of the last few decades, wages across the economy have basically stagnated. We've gone through several massive bouts of sustained joblessness: 3.8 percent unemployment has become a fleeting rarity since the 1970s. Meanwhile, the Fed's target of two percent inflation has functioned more like a ceiling; we simply haven't gone above that threshold, even in the aftermath of the worst economic crisis in almost a century.
That isn't just bad for the economy in some technical sense. Low wages now can shape wage offers for the rest of a person's career. Long bouts of unemployment leave people disconnected from the labor market, and make it harder for them to reconnect even when times get better. Higher unemployment rates also allow business to be picky, refusing to hire people for all sorts of capricious reasons, ranging from a felony history to a lack of a college degree to disability and more.
In other words, chronically undershooting the Fed's employment responsibilities does lots of damage to on-the-ground human beings, their families and their communities. And that damage compounds over time. On the flip side, of course, the business owners and big banks Fed officials are often in contact with prefer lower labor costs and lower inflation so they can make bigger profit margins.
Rolling that imbalance back will require the Fed to tolerate lower unemployment, and thus more potential inflation, for a few years than it might have done in a vacuum. Employers need to be put through an extended period where they're forced to raise wages for everyone, forced to hire everyone who comes along regardless of what inconveniences they may pose, and get more vulnerable Americans reintegrated with the labor market over an extended period.
Of course, the Fed can't do this all on its own and Congress and the rest of the government have to do their parts as well. But the central bank has a certain amount of power to restrain economic growth. And the fact that its interest rate target is above zero — currently between 2.25 and 2.5 percent — means it's at least restraining growth somewhat. The Fed should get out of the way, and give the economy every last bit of running room it can.