Fed’s Concerns

Wall Street traders, especially during the last couple of weeks, have voiced doubts about the Fed’s intentions. On the one hand, they note how the minutes of the last Fed meeting expressed concerns about the stock market. Yet on the other, the Fed has reaffirmed its determination to raise interest rates and shrink its balance sheet. From a trader’s point of view, this must sound confusing, since most of them believe that the Fed’s main aim is to enrich them and make their lives easy. But they are mistaken. For the Fed, they and markets are far from the main concern. Policy makers put the state of the economy first and with it an urgent need to adjust their basic policy stance, to “normalize” it, as Fed Chair Janet Yellen has said on numerous occasions. Their sense of urgency in this has if anything ratcheted up as news from the nation’s labor markets has begun to signal developing economic bottlenecks and even ultimately the prospect of inflation.

The Fed’s drive to normalize is no small thing. Policy makers are acutely aware how far past efforts to combat the crisis of 2008-09 and then the slow recovery removed policy from historic norms. Taking short interest rates down to zero stood as a remarkable move next to historic levels that typically saw the federal funds and treasury bill rates well in excess of the rate of inflation. The bond-buying programs through which the Fed implemented its waves of quantitative easing have blown up the Fed’s balance sheet almost 450 percent from about $800 billion in 2008 to $2.8 trillion in 2012, to $4.5 trillion earlier this year.

There was probably little else the Fed could have done in the circumstance, but the extent to which policy has lost the bearings offered by history has rightly given policy makers pause. Many Fed governors and regional Fed bank presidents have tried to describe the ills that might arise should the Fed fail to normalize. Some have worried about the tendency for historically low rates and historically high levels of liquidity implied by the bloated balance sheet to foster financial bubbles, not unlike the one that crippled the economy when it burst in 2008-09. Others have worried about the potential to put the country onto an inflationary spiral of the sort that caused so much economic havoc in the 1970s and early 1980s. Even those at the Fed who resist the temptation to connect the dots on what might happen must feel uneasy with matters so far from their usual benchmarks.

Of late, news from labor markets has added to the urgency behind the Fed’s normalization drive. The unemployment rate has fallen to a near record low 4.1 percent of the nation’s workforce. Alone this suggests that the productive capacity of the economy may have reached a point where further growth might soon become problematic. Some argue, with merit, that this situation is less threatening than it might seem, that a considerable number of potential workers remain outside the workforce and so not counted in the unemployment rate. Such reassurance, however welcome otherwise, cannot entirely erase concern about the impact of a tight labor market on growth potentials.

Keeping that concern in the front of policy makers’ minds is the recent acceleration in wages and costs to business. According to the Bureau of Labor Statistics, hourly labor compensation has accelerated from a 1.0 percent rate of advance last year to a 3.4 percent annualized rate of advance this year through September, the most recent period for which data are available. This jump may be a welcome change for working men and women who have seen their living standards stagnate for years, but it also tends to confirm concerns that a tight labor market may constrain growth potentials.

It would stretch the evidence to say that the economy and the Fed are at a critical point. It would not stretch things at all to conclude that the economy and the Fed are much closer to that point than a year ago. That alone stands as motivation enough for the Fed to normalize its policy posture, to bring short-term rates up at least to the level of inflation, and to shrink its bloated balance sheet. Only then would monetary policy reach a state where it could ease strains should the economy come to face constraints. One wag has described the effort as one in which the Fed wants to raise interest rates so that, should the need arise, it could reduce them. This may make it all sound silly. It is not, and it is not far from the mark on the Fed’s intentions.

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