US labour market data is improving, leading some to wonder why the Fed raised rates in December before making dovish noises this month.
The US economy looks stronger now than it did in December, with jobs numbers continuing to improve and unemployment heading into territory that once upon a time would have been called full employment.
The Fed is now looking at more fine-grained measures of unemployment. Many people remain in part-time jobs while looking for full-time jobs. The economically inactive population among people of working age remains high by historical standards. These measures mean that the Fed will delay for longer, the Federal Open Markets Committee said in its latest minutes.
In the textbooks, the Fed cares about its dual mandate – to pursue full employment and maintain a stable price level. The Phillips Curve, which posits trade-offs between inflation and unemployment, is its analytical model for this. So the Fed looks at labour market data and the price level to figure out where on the Philips Curve the US economy is. That allows it to set interest rates in an attempt to influence both employment and inflation.
Three sources make me wonder whether this really is a complete picture of how the chairwoman Janet Yellen and her team decide on the rate that matters.
Ask a Fed governor and they’ll tell you that unlike HSBC they have no desire to become the world’s global bank.
But to the economic historian Barry Eichengreen, with the US economy diverging from the rest of the world, it looks like the Federal Reserve may not be entirely insensitive to what’s going on elsewhere.
The Fed has regularly organised swap lines to crisis-hit countries, and through regular mentions of its terms of trade and the US’s exchange rate, it has considered the impact of its interest rate rises on the economies of its trading partners, albeit in a roundabout sort of way.
For the long list of countries with their currencies pegged to the dollar – including every nation of the Gulf Cooperation Council, with an asterisk next to Kuwait – that is good news. Emerging markets tied to the dollar subordinate their monetary policies to those of the US.
That is fine if emerging markets grow when the US grows. But the IMF has released numerous warnings about capital outflows, slower growth and mounting corporate debt piles in emerging market countries.
If the Fed is cognisant of its role as the world’s central bank, it should act more dovishly than current US data suggests.
I recently read The Power and Independence of the Federal Reserve by Peter Conti-Brown at Wharton.
Conti-Brown offers a sensitive and detailed portrait of the operations of the Fed. Politics – institutional, rather than domestic – plays a key role in the decisions of Fed actors. Under the Richard Nixon, the Fed chair Arthur Burns read from the same songsheet as the president. Fed chairs have proved willing to accept constraints – by deferring to other political institutions – on certain areas of their authority in exchange for freedom in others. Alan Greenspan was opposed to gaining further regulatory oversight over banks, perhaps because he did not wish to do so.
What emerges from Conti-Brown’s book is a picture of the Fed as unwieldy, and significantly influenced by the legal and institutional dynamics of its founding.
There is a long and detailed political science literature on the US supreme court, where the stakes are high. This literature finds that political preferences partially explain some of the decisions justices make. Even in putatively technocratic institutions, public and elite opinion matter. That is why people who disagree with a decision may be partially correct when they sense that purely technical factors were not the sole motivation behind a decision.
And that is why market froth related to slowing growth prospects in China, though not included in many Fed models, may be taken into consideration by dovish Fed governors. And, similarly, the opinions of market participants who believe that the zero lower bound is distortionary and encourages excessive risk taking may also weigh on the minds of hawks.
Larry Summers, a former US treasury secretary, has another point of view – the Fed’s mental models are dated. It is looking at the textbook Phillips Curve suggested by Clinton-era data – that unemployment’s lowest bound is somewhere around 5 per cent, when more fine-grained data suggests otherwise. The economist Brad DeLong thinks that the Fed may just be ignoring the most plausible explanation of the economy’s poor performance since 2008 – that higher expected inflation is needed, and that there are several ways the Fed could encourage this, one of those being the move to a 4 per cent, rather than a 2 per cent, inflation target.
These are theoretically well-founded arguments about the right way to interpret the panels of economic data facing the Fed.
But the moral of Conti-Brown’s book is that the Fed is subtly more complicated than a black box of rational model-following decision-makers. It also listens to markets, and to what’s happening overseas. The Fed is staffed by humans who respond to the distribution of opinion around them, including market participants and foreign countries. That may be part of why Ms Yellen is making dovish noises even as labour markets improve.
Adam Bouyamourn covers economics for The National.
business@thenational.ae
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