The Fed Pursues Net Neutrality

  • The Fed Pursues Net Neutrality
  • The End Of An Era For The ECB

After completing her first year at college, my daughter moved back home for the summer about a month ago. Her final exams concluded only a short time before the required departure from the dorm, so her packing was a little harried. She arrived with all manner of suitcases, boxes, and trash bags, all filled with a mix of clean and dirty clothing.

Weary from studying, she spent the first week at home rising at noon and returning to bed for a nap a few hours later. The piles of debris (littered across several bedrooms, bathrooms, and the hallway) seemed to grow, rather than dissipate. After being patient for a considerable interval, my wife and I concluded that we had offered too much accommodation.

The Federal Reserve further reduced its level of accommodation by increasing interest rates once again this week. This was the seventh step in a string that began in December 2015. The move was widely expected, so attention was primarily focused on where the Fed might go from here.

Fed leader Jerome Powell began his second news conference by noting that “The economy is doing very well.” And so it is. Growth is strong, unemployment is at a 17-year low, corporate profits are exceptional and asset markets have produced strong returns. Powell sounded optimistic about the influence of tax reductions on demand, and hopeful about their prospective impact on the economy’s supply-side.

Keeping a balance between these two will be critical to keeping the price level in check. After running below the Fed’s target for a very long time, inflation measures are coalescing around 2%. At its May gathering, the Federal Open Market Committee clarified that its target was “symmetric,” meaning that readings slightly under or slightly over the desired level would not necessarily prompt corrective action.

The Fed’s inflation projections remain benign. The consensus calls for annual increases in the price level that peak at a 2.1% annual rate; the upper end of the range of forecasts is just 2.3%. This is partly a reflection of the secular governors on inflation, which include corporate resourcefulness in containing costs and the power e-commerce has given consumers to shop efficiently.

This seemingly ideal combination—strong growth with low inflation—begs the question of why the FOMC is raising interest rates. The answer is twofold.

Firstly, if growth continues along its recent trajectory, inflation may become more of a risk. If demand grows more rapidly than capacity, idle resources will be called into production until they are fully utilized. Once that point is reached, the costs of those resources may be subject to upward pressure. Wages have not risen rapidly, even with unemployment at very low levels; but reports of labor shortages are multiplying. The Phillips Curve may be weakened, but it is not deceased.

Secondly, there is a risk in leaving policy too easy for too long. The FOMC’s median estimate of the long-term Federal funds rate is 2.9%, a full percentage point above where rates are now. And the Fed’s balance sheet remains well above the level most economists think is needed to conduct open market operations. Financial conditions are very easy, and this might facilitate market excesses that could destabilize the system.

To be sure, there are uncertainties about where the red lines are. We struggle with what Chairman Powell called “unobservable quantities,” such as the natural rate of unemployment and the “neutral” interest rate (which is neither restrictive nor stimulative). Nonetheless, it is fair to say that the current level of interest rates is quite low, given the strength and duration of the expansion.

Simply stated, the U.S. no longer needs monetary policy that is so easy. The Fed’s benign inflation outlook might be due, in part, to the expectation for further increases in interest rates; if those increases are not realized, future inflation might certainly be higher.