MAKING CENTS — Going Up?
One of the key economic stories shaping the last half of 2015 is when and by how much the Federal Reserve will raise its federal funds rate.
The federal funds rate — the overnight rate for bank-to-bank lending — is the Fed's chief monetary policy tool. Where this rate is set affects other borrowing rates broadly across the economy. It has been set artificially low for several years now in an attempt to both stabilize the financial sector and spur economic growth.
The downward march of the policy rate began back in September 2007, when the committee dropped the federal funds rate from 51Ú4 percent to 43Ú4 percent. As the crisis unfolded, the Federal Open Market Committee pushed the rate lower, and it reached zero, effectively, in December 2008.
It has been there ever since.
HOW DID WE GET HERE?
The economic conditions that evoked that policy response in 2008 were extraordinary, to say the least.
When the Fed's policy rate hit zero in December 2008, the official rate of unemployment had already climbed from a low of 4.4 percent to 7.3 percent, and was rising fast.
It would peak at 10 percent in less than a year. Between December 2007 and February 2010, U.S. payrolls fell by more than 8.7 million workers.
In the fourth quarter of 2008, real gross domestic product (GDP) contracted at an annualized rate of 8.2 percent. The economy's performance in that quarter was its worst in 50 years.
In December 2008, the economy had already been in recession for a year. The recession wouldn't officially end until the following June. When it finally did end, the cumulative loss in national output amounted to the greatest contraction in economic activity in the postÐWorld War II era. The recession was extraordinarily deep, and it was broad.
By early 2009, a substantial majority of U.S. industries had either stopped hiring or were cutting their workforce. Construction activity and employment entered their deepest and most protracted de- cline since World War II. Industrial production was hard hit, too.
In January 2009, for instance, four out of five manufacturers and other industrial producers were generating output below levels six months earlier. Retail spending was off more than 10 percent from year-earlier levels.
Measures of consumer confidence had fallen to near historic lows. Virtually every region of the nation and every economic sector were under substantial stress.
THE CURRENT PICTURE
Let me contrast this picture of the state of our economy at the end of 2008 and early 2009 with the picture we see today. Since bottoming out in the sec- ond quarter of 2009, real economic output is up about 13 percent. Said differently, the economy is 81Ú2 percent larger than its pre-recession peak.
To give a sense of the scale of improvement, the U.S. economy has added activity about equal to the economy of Mexico.
Although the pace of improvement in output has been slower than hoped for, by most measures, real GDP is approaching its full current potential.
From its peak of 10 percent, the rate of unemployment has fallen to 5.3 percent. This level of unemploy- ment is just a shade above what some economists think is consistent with full employment.
A broader measure of unemployment and under- employment — one that includes marginally attached workers and those working part-time involuntarily — continued to fall in July to 10.4 percent.
From the employment trough, the economy has added more than 12 million jobs, consumer spend- ing is almost 14 percent above its recessionary bottom and consumer confidence has recently climbed back to near, and by some measures above, pre-crisis levels.
To sum up, the economy has come a long way in the more than 61Ú2 years since the federal funds rate hit bottom. The subtext is that the recovery has been slow.
It's taken more than six years of recovery to accomplish what I just described. The recovery has proceeded at an average annual pace of expansion of only 2.1 percent.
Over this period, the economy has faced a number of headwinds and shocks. We've pushed through several domestic fiscal showdowns, including one federal government shutdown, two major winter weather events, geopolitical tensions and wide swings of global energy prices.
Most recently, the Greek and European Union stare-down was unsettling with its potential for a major financial event or worse. These develop- ments slowed activity, shook confidence and bred cautious economic behavior on the part of Ameri- can consumers and businesses. These spells of cautious behavior have contributed to the slow pace of recovery.
INCREASED INTEREST IN INTEREST RATES
Indicators released over the past two months suggest an upturn in U.S. economic activity. The first estimate of second quarter real GDP growth came in at an annualized 2.3 percent, putting first- half average growth at a modest 1.5 percent.
Average job growth from April to June, although weaker than the red-hot 260,000 per month average of 2014, was nonetheless an impressive 221,000 per month. Meanwhile, the jobless rate dipped to 5.3 percent, its lowest since April 2008.
On a 12-month basis, measures of headline inflation continued to be tepid, reflecting lower oil prices, while trimmed-mean inflation held steady.
Which leads to everyone's favorite question: What does this mean for interest rates?
I still believe this will be the year for liftoff and that waiting too long to raise rates poses its own risks.
I know not everyone agrees with me and there are those who believe we should wait until we're nipping at the heels of 2 percent inflation. But monetary policy has long and variable lags, as Milton Friedman famously taught us.
Specifically, research shows it takes at least a year or two for changes in monetary policy to have its full effect. We're therefore dealing with a now-famous analogy: the car speeding toward a red light. If you don't ease up on the gas, you'll have to slam on the brakes, possibly even skidding into the intersection.
Waiting until we're close enough to dance with 2 percent means running the very real risk of having to dramatically raise rates to reverse course, which could destabilize markets and potentially derail the recovery.
Many see a safer course in starting sooner and proceeding more gradually.
However, it's important to remember that when the Fed does raise interest rates, they will not be instituting tight policy; they will be easing back on extremely accommodative policy, and those are two very different things.
Policy will continue to be accommodative, and the Fed's $4 trillion-plus balance sheet will con- tinue to provide substantial stimulus. There's no need to worry that we're cutting the legs out from underneath the economy.
All in all, things are looking good. Personally, I see growth on a solid trajectory — full employment is just in front of us, wages are on the rise and inflation is gradually moving back up to meet the Fed's (2 percent) goal.
I can't tell you the date for liftoff, but I can say that it is going to be an interesting rest of the year for monetary policy, and the Fed in general.
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