I rarely discuss macroeconomic issues on the blog, or in my day to day life. I find myself far more interested in how individual consumers and households make decisions than in how those decisions affect the big picture. To be honest, it kind of overwhelms me when I start thinking about all of the moving parts. There are so many factors to consider, which is why macroeconomic models are so difficult to build and require so many assumptions.
However, since I mentioned inflation in my my post about important things that everyone should understand, I wanted to touch upon the current state of price growth and how economic policies might affect it. Here’s what the FOMC said about inflation in it’s last statement from July 27th:
“Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.”
When they say “medium term” they mean that inflation should be back at 2% by 2013, at least according to June’s projections. On the whole, policymakers have seemed pretty unconcerned about the low price growth in the U.S. over the past few years. It gets mentioned, but generally without red flags. Raising interest rates hasn’t seemed reasonable given that the labor market is still recovering and growth has been sluggish. Some economists are upset that the Fed isn’t considering less conventional tools like nominal-GDP targeting or adjusting it’s inflation target upward from the current value of 2% in order to increase prices. Larry Summers wrote a series of posts following the summit in Jackson Hole about why he believes that the Fed should be more concerned about inflation and that interest rate increases aren’t warranted any time soon. The argument is clear: if we want a 2% average, then inflation will have to be higher than 2% for a while given that’s it’s been lower than 2% for several years. This is basic statistics. The more complex part of this argument is the notion that having this higher target will also put in place a higher natural interest rate which would give policy makers more room to maneuver since a zero lower bound wouldn’t be as restrictive. John C. Williams explains this well. I like to think of it as the “reach for the stars” metaphor – aiming high gives you a lot more space to fall somewhere that is at least better than where you started.
Let’s think about this though. Would a higher natural interest rate really make all that big of a difference? It’s clear that both types of inflation (demand-pull/cost-push) are lacking in the current economy. People are still tepid on buying things and consumption growth, though positive, is slower than the norm in previous years. Additionally, input prices are down, especially because of low oil prices. Typically, economists expect low interest rates to stimulate growth and subsequently spur price increases. It’s clear though, that this hasn’t been the case in recent years. Rates have been 0% or near 0% since 2008 and it hasn’t caused people to adjust their behavior as the models would predict. People are still behaving cautiously, hanging on to excess liquidity and saving more than they did before the recession. For many, 0% interest rates seems like the norm at this point and don’t provide any incentive to consume more. Getting people to actually buy more things, which will subsequently boost the labor market and overall growth, is going to require more than just keeping interest rates low. I think people adjust their expectations based on their experience; every decision is bench-marked about what’s relatively normal. To extend the metaphor, people don’t really want to reach for anything because they’re too afraid of leaving Earth at all, especially when at least being on solid ground seems better than the uncertainty and loss that many people suffered as a result of the Great Recession.
I understand why people are upset at the idea of raising rates right now given low growth and inflation rates. What I don’t understand is how simply not raising rates or creating more room to vacillate between 0 and r* via a higher inflation target is a solution. Maybe I am underestimating the potential effect of relatively lower rates on the individual’s behavior, but I just don’t think that people are that reactive to such subtle changes. Again, people are very cautious right now. Low is just low, relative to what’s normally higher and vice versa; if people don’t respond to a 0% rate I don’t think they’ll respond to a seemingly lower one either. And in change in expectations that could result from a new policy would likely take years to sink in; who knows where we’ll be by then.
This idea runs parallel to the e experimentation with below 0% interest rates that we’ve seen in Europe and Japan, which has generally not gone well. It seems like doing this would just be nominally shifting everything upward by 2% without addressing the real structural problems: weak consumer demand, job skills mismatches, and low business investment which continue to persist even in the face of minimally low borrowing costs.
As a side note (but related to the aforementioned structural issues), I also think that this lower than expected growth may be partially reflective of how the economy has changed. So much of what people consume now is less tangible than manufactured goods (i.e, information, media etc.). At the same time, many of these goods are consumed for free or at very low costs and suppliers are constantly price gouging each other to keep price low and maintain users. I think it’s possible that lower inflation may be a natural result of transitioning into a more service-based economy.
At any rate, it seems unlikely that the Fed is going to try any unconventional policy measures at this point. I also doubt that they will raise interest rates this year. This doesn’t really concern me. I agree with Williams’ suggestions that fiscal policy involving more investment in education, infrastructure, and research is more well suited to address the current slow growth that we are facing and confront the issues in the long-term. Monetary policy, in this case, is a just a tool to induce changes by manipulating expectations, but when expectations are so low, there’s very little to gain. Reach for the stars if you must, but you won’t get anywhere if you can’t even get off the ground.