Though the Fed rate hike decision last week seemed inevitable -- and long overdue, at that -- is it possible Fed Chair Janet Yellen actually made the wrong call?
“Reform the Fed,” shouted a recent piece from The Week. Yellen has left us little choice, the contrarian argument continued, after she “betrayed the American people and will go down as one of the worst chiefs of the Federal Reserve in history.”
“The Federal Reserve has raised rates too soon,” agreedThe Guardian’s economics blog, predicting even odds that Yellen will have no choice but to back down and reverse the decision. To hear CNBC’s Alex Rosenberg tell it back in September, when it comes to interest rates, “hope appears to be the Federal Reserve’s strategy of choice.”
There’s a lot of anger directed at the central bank these days.
Now, it’s true that we’ve entered an odd political moment, one in which previously esoteric government functions have become political bread and butter. When Barak Obama was elected, who could have predicted that the debt ceiling would swiftly become part of Thanksgiving conversations? Or that by the midterm election many voters would develop strong opinions about the Export/Import Bank?
Yet even by today’s standards last Wednesday’s decision to raise interest rates by 0.25% has garnered an impressive amount of attention, a lot of it from people who think that the Fed made a mistake. What’s the uproar over?
In a word, inflation. The Fed’s critics argue that we need more.
And in a sense they’re right. Inflation has been well below the Fed's 2% target for several years now, averaging 1.6% in 2014 and 1.46% in 2013 alone. At several points in 2015, the numbers actually dipped negative (the term, appropriately enough, is deflation), and, barring an extraordinarily odd December performance, will average an anemic 0.1% for the year.
That’s nowhere near 2%, which is important, critics point out, because that figure isn’t a ceiling. It’s a goal. Contrary to what many hard money truthers assert a managed rate of inflation can have many macroeconomic benefits. It’s why the Fed’s mandate isn’t 0%. Economists actually want a certain level of inflation over time -- just, not too much.
Inflation encourages spending and investing by eroding the value of money that sits fallow in bank accounts. For individuals, that’s frustrating, because we want our money to stay whole even if it’s stuffed under the mattress. At 2% per year a Benjamin today becomes $98 by next Christmas, becomes $96.04 the one after that and rings in 2018 at $94.11. For the economy as a whole that’s a good thing, though, because we want people putting that money to work.
Stagnant pools of capital are just about the worst thing that can happen in capitalism. It’s a feature of what economists call a liquidity trap, as spending drops in anticipation of future events such as job loss or deflation. Yes, it’s weird to think about someone saying, “I want this loveseat, but the rate of inflation is low this month so maybe I’ll hold off…” but it shows up in areas like banking interest rates and investment returns, and those do influence consumer decisions.
Consumers tend to sit on cash when there's incentive to do so, and that sucks demand out of the economy. Instead we want cash spent and savings invested. A gentle rate of inflation can encourage that, without going so far as to really punish non-investing savers.
It’s also good for anyone in debt, so sit up a little bit straighter, Millennials. As long as the interest rate is fixed or capped, that debt gets worth less over time. I borrow that $100 today and pay it back next year… when it’s only got $98 worth of purchasing power in today’s terms, and ideally, I’m making a little bit more to compensate.
Is it any wonder why bankers generally hate it?
In fact, the war on inflation is one of the great distorting factors in our economic debate. Many politicians and economic experts warn unflaggingly against inflation as though it would be an unmitigated disaster, but what they actually mean to say is that too much inflation can be disastrous.
As with people who say debt will make us Greece, the people who argue that we’re bound for Weimar-style wheelbarrows of cash are engaging in meaningless hyperbole. Yet buried in the rhetoric is a good point: inflation can spiral and go too far fast.
And that’s what traditional economics teaches us should be happening right now. Over the long run, low interest rates should drive up inflation by triggering a wage/price spiral: easier cash will drive up hiring, which improves wages. As wages grow faster than the supply of goods businesses can charge more for the same product, which continues to generate cash flow and keeps the spiral going.
It’s why the Federal lowers interest rates in the face of a recession and raises them again to slow the economy down.
But something’s missing from this calculation. Inflation is low -- and so are wages. Certain sectors of the economy have been doing well but as a whole American pay scales have flatlined, sucking the starter fuel out of the spiral.
In a nutshell, that’s the argument from the Fed’s critics. Not only, they argue, is there no current inflation to justify raising rates but little evidence that it’s coming.
To be sure, there are plenty of people defending this decision as well. Why?
The American economy is a big, slow boat, they argue. A little bit of inflation goes a long way; tip the balance just a little too far, and suddenly people find their retirement accounts losing a noticeable amount of money from year to year, and that would be just as bad.
Which is why the Fed chose to act, not in response to observable conditions but as a prophylactic to what might develop. It takes months for an interest rate change to show up in on-the-ground data, so raising interest rates once inflation hits 2% is essentially cranking the wheel after you’ve hit the iceberg.
Yellen is banking on the idea that there’s a big one somewhere up ahead in the mist, and the only thing worse than slowing down the economy is running into it. Her critics are arguing, in essence, that this is inflation paranoia run rampant at the potential cost of jobs and real wages.