At the conclusion of its two-day meeting on July 26, the FOMC kept the Fed Funds target rate unchanged. While this was expected by the financial markets, I thought that the FOMC might still actually raise the target rate. At the very least, I expected some hint in its statement that it might act sooner than markets were expecting.
In fact, I got neither. To my surprise, the FOMC actually issued a more dovish statement than I had expected. While the low rate of inflation is the reason that most Fed watchers point to in support of leaving the Fed Funds target rate unchanged, the FOMC said that it was also looking for further gains in employment. That was especially surprising, given that the unemployment rate now stands at 4.4%, a level that most economists would view as at or near full employment.
To put this in perspective, a national unemployment rate of 4.4% is of course an average of the unemployment rates across all 50 states. By definition, some state unemployment rates are below that average, while others are above the average. According to the Bureau of Labor Statistics, that average unemployment rate currently ranges from a low of 2.3% in Colorado and North Dakota to a high of 6.8% in Alaska.
Without delving into the specific circumstances of every state’s unemployment rate, it is reasonable to suggest that those states at the low end of the unemployment rate spectrum, below 3%, are unlikely to see significant further gains in unemployment as a result of maintaining a low Fed Funds rate. In fact, low interest rates in these states raises the risk of higher inflation. For example, low rates in those states can be a key factor in pushing house prices higher, which could keep households at the low end of the income spectrum from becoming homeowners and cause others to take on more debt.
Employment gains in those states with the highest unemployment may still be possible; but it seems that keeping interest rates low is not the most efficient way to target employment gains in them. Instead, a more targeted fiscal policy, at the state or federal levels, has a better chance of delivering the results with greater precision (and therefore at less cost).
It is also possible that an increase in the labor force participation rate – which at 62.8% currently is down 4.5 percentage points from the peak of 67.3% in 2000 and also down 3.3 percentage points from 66.1% in the summer of 2008, immediately before the financial crisis – could deliver additional (non-inflationary) job gains, raising employment without reducing the unemployment rate. However, much of the decline in the labor force participation rate is believed to be due to demographic factors, especially the aging of the workforce. In addition, there may be a mismatch between the skills needed by employers and those possessed by the unemployed that may be hard to bridge. Nevertheless, at least one business, Men’s Wearhouse, has recently been playing for a boost in its sales of suits as a result of expectations of more men re-entering the workforce.
Under the circumstances, the emphasis by the Trump administration on boosting jobs seems out of step with the current economic environment. Clearly, the administration is using the loss of jobs due to outsourcing as a populist means of supporting its trade policy goals and also playing to its base of support. For example, late in 2016, Mr. Trump trumpeted the success of his efforts to keep Carrier Corp. from moving some of its operations from Indiana to Mexico. Yet, the unemployment rate in Indiana is now 3.0%, down from 4.5% a year ago. At this time, Indiana does not require the help of either the Federal government or the Federal Reserve to reduce unemployment.
Besides promoting further job gains, the FOMC has been worried about an easing of the rate of inflation below its target rate of 2%. FOMC members predict that inflation will be 1.6% in 2017, which is below that target. But the decline in inflation is undoubtedly due in part to earlier declines in the prices of oil and natural gas and also to an increase in the value of the dollar.
The price of oil has rebounded sharply from a low of $42 per barrel in mid-June to around $50 currently. Likewise, the U.S. dollar is down more than 10% since peaking in January. (The decline in the dollar has been a positive contributor to corporate earnings gains in the 2017 second quarter, but it will also raise the price of imports going forward.)
The Fed sees inflation trending back toward its 2% target in the medium-term. The recent gain in the price of oil and decline in the dollar, if sustained, could bring headline inflation back to 2% sooner than that.
At the very least, the decision to hold off on normalizing the Fed Funds rate because of low inflation seems like splitting hairs. The difference between the expected 2017 inflation rate of 1.6% and the target rate of 2% is small and inflation could easily rise back to 2% or higher on short notice.
Perhaps it made sense for the FOMC to hold off on the next Fed Funds target rate increase until September, when Chair Janet Yellen is scheduled to hold a post-meeting press conference to explain the Fed’s decision. However, futures markets currently see a zero percent probability of a rate hike in September and only a 50% chance of one in December.
Loomis Sayles Vice Chairman Dan Fuss recently said that the Fed was caught in a “stinky box” where its policy actions are being constrained by non-economic factors, including geopolitics and domestic politics. In the absence of a clear weakening of economic fundamentals, the longer the Fed waits to normalize interest rates, the more likely it will eventually come to be seen as being constrained in its decision-making by politics, which could reduce its credibility in the eyes of the financial markets.
July 31, 2017
Stephen P. Percoco
Lark Research, Inc.
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Linden, New Jersey 07036
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