Why the Fed Will Raise Interest Rates This Year

Despite the apparent slow down of economic activity during the first quarter of this year, it is likely the Fed will still have to raise interest rates in the near future. This reason why is that households are increasingly expecting their nominal incomes to rise and this typically leads actual wage and salary growth. This can be seen in the figures below.

The first figure shows households' expected nominal income growth over the next year. It comes from the University of Michigan/Thompson Reuters Survey of Consumers where households are asked each month how much their dollar (i.e. nominal) family incomes are expected to change over the next 12 months. This measure averaged near 5 percent prior to the crisis, but then crashed and barely budged for several years. Finally in 2013 it acquired escape velocity. Since then it has been slowing trending up with a bit of a pick-up in the last year.

The next figure plots this series against the employment cost index, but now at a quarterly frequency. The figure suggests expected nominal income growth leads actual nominal income growth. This indicates  wage and salary growth is primed to start accelerating. 

Now the data only runs through March. A lot of disappointing economic news has come out since then. So it will be interesting to see whether this trend is sustained next month. If this New York Times article is any indication, we can expect the series to continue trending up and actual incomes to follow:

WASHINGTON — The number of Americans filing new claims for jobless benefits tumbled to a 15-year low last week and consumer spending rose in March, signs the economy was regaining momentum after stumbling badly in the first quarter.

The economic outlook was brightened further by another report on Thursday showing a solid increase in wages in the first quarter.

"This morning's reports all point to an economy that is doing a lot better than the near-stagnation in first-quarter G.D.P. suggests," said Paul Ashworth, chief United States economist at Capital Economics in Toronto.

So it appears the Fed may have no choice but to tighten by the end of the year.

P.S. Justin Wolfers observes that the Q1 slowdown in GDP has become a reoccurring development. Since this is seasonally-adjusted data it should not be happening. Consequently, Wolfers notes we should not put too much faith in the Q1 numbers. This is another reason to believe that wages are primed to take off.

Update: Here is the relationship between the U6 minus U3 unemployment rate spread and the expected nominal income growth series. I have used the 5-month centered moving average trend on expected nominal income growth to make the graph clearer:

About that Dual Mandate...

George Selgin says we should do away with it:

The Federal Open Market Committee is in a pickle. After its last meeting, it suggested that it would soon start raising interest rates as a way to head off inflation. Recent inflation numbers, showing an uptick in the core inflation rate, make that step seem as necessary as ever.

But disappointing growth projections, along with the dollar's international appreciation, are giving committee members cold feet.

The FOMC's dilemma is rooted in the Fed's so-called "dual mandate," calling for it to achieve both "maximum employment" and "stable prices." Whenever inflation and employment seem to be headed in opposite directions, the Fed has to compromise.

Wrong compromises aggravate the business cycle; and even if the compromises are correct, the Fed's uncertain direction puts a damper on growth.

Realizing its flaws, some favor just scrapping the dual mandate's "maximum employment" clause, leaving the Fed with a solitary inflation target.

The dual mandate's champions reply that, while inflation targeting might make monetary policy more predictable, it could also call for the Fed to tighten at times — the present might just be one of them — when doing so means putting the brakes on an already slowing economy.

So what's best, a slippery dual mandate or a stable-inflation straitjacket? Neither.

You will have to read the rest of his article to find out what he thinks should replace the dual mandate. Here is a hint: he agrees with my vision for narrowing the Fed's mandate.

A Partial Solution to Income Inequality

I want to come back to one of the points from my last post. There I noted the global economy was hit by a series of large positive supply shocks beginning in the mid-1990s: the rapid advances in technology and the opening up of Asia. The former raised productivity while the latter increased the world's labor supply. Both pushed up the return to capital and put downward pressure on global inflation. 

This run of positive supply shocks continued into the 2000s--productivity growth peaked between 2002 and 2004--but was interrupted by the Great Recession. It now appears to be returning to full stride. This time, though, the supply shocks are not coming from further increases in the global supply of labor, but from further technological advances. The increased digitization, automation, and overall smart-machining of our economy is and will continue to bring huge productivity gains. For example, by the end of 2016 there will be 30 U.S. cities with driverless cars, artificial intelligence will be diagnosing illness, and 3D printers will be making practically everything including themselves. And oh yea, robots will be delicately picking fruit. These examples highlight what Erik Brynjfolsson and Andrea McAfee call the second machine age where we will see rapid productivity growth that will reinforce the high return to capital.

How the world handles this second machine age over the next few decades will be, in my view, one of the biggest economic challenges going forward. Rapid technological advances are ultimately good for long-run growth, but in the short run they can be very disruptive to many jobs and industries. This has always been true, but the pace and size of these disruptive supply shocks are likely to increase. It is true that we do not see much evidence in the data yet for this process, but I chalk that up to measurement problems and that we are only the cusp of these changes. In any event, I suspect that this issue will make the present-day concerns over secular stagnation, liquidity traps, saving gluts, and the Japanification of Europe look quaint. 

One widely-held concern about large positive supply shocks is that they will shift income from labor to capital. This concern can be seen in this The Economist's discussion of the Asian supply shock back in 2005:

China's impact on the world economy can best be understood as what economists call a “positive supply-side shock”. Richard Freeman, an economist at Harvard University, reckons that the entry into the world economy of China, India and the former Soviet Union has, in effect, doubled the global labour force (China accounts for more than half of this increase). This has increased the world's potential growth rate, helped to hold down inflation and triggered changes in the relative prices of labour, capital, goods and assets. 

The new entrants to the global economy brought with them little capital of economic value. So, with twice as many workers and little change in the size of the global capital stock, the ratio of global capital to labour has fallen by almost half in a matter of years: probably the biggest such shift in history. And, since this ratio determines the relative returns to labour and capital, it goes a long way to explain recent trends in wages and profits.

The trends, of course, being the higher share of income going to capital and the slow growth of real wages. It is a natural consequence, the article argues, of the higher returns to capital generated by such supply shocks. The rapid technological advances, therefore, will only reinforce these developments since they too raise the return to capital. Woe is the labor share of income.

Another related concern is that that this growth in global capacity will not be matched by sufficient demand given the declining share of income going to labor. There will be a persistent demand shortage as argued Dan Alpert in his "Age of Oversupply". He worries there will be a persistent global glut.

So what should be done? Left-of-center solutions range from more government spending to make up for the spending shortfall to a basic income policy to offset the decline in labor's share of income. One of the more interesting proposals, in my view, from the left is to have the federal government invest in the SP500 on behalf of its citizens. Any earnings from this investment would be distributed among households. This would make everyone a capitalist and thereby empower them to benefit from the gains of the second machine age.

Eric Lonegran and Mark Blyth, for example, argue the U.S. government should create a sovereign wealth fund (SWF) to do just that. They would have the federal government sell more treasury securities to fund the SWF which would then invest the funds in a stock market index fund. The earnings would be sent to its shareholders, U.S. taxpayers. From a macro-finance perspective this is a clever idea, but from a political-economy perspective I worry that investing decisions would become very political and messy. 

So let me propose another solution, one that allows markets to support growth in labor's share of income. It is a very simple solution: let the price level reflect changes in productivity while stabilizing nominal income growth. Put differently, central banks should aim to stabilize the growth of nominal wages, but ignore changes in the price level. This would allow real wages to more closely follow the rapid productivity growth.

To see how this would work recall the large positive supply shocks from Asia and technology that culminated in the productivity boom of 2002-2004. Both of these developments raised the return to capital and put downward pressure on inflation. All else equal, the higher return to capital should have resulted in a higher market-clearing or 'natural interest rate' while the downward drift in inflation should have supported the growth of real wages. Instead, the Fed offset the decline in inflation by lowering its target interest rate. Given the Fed's monetary superpower status, this lowering of short-term interest rates was replicated across much of the world. So just as the fundamentals of the global economy were pointing to higher real interest rates and lower inflation, the Fed and other central banks moved in the opposite direction to keep inflation stable. These actions served to raise firm's profits while reducing labor's share of income.¹

Here's why. A permanent rise in productivity means lower per unit production costs for firms. In turn, this means greater profit margins for a given sales price. Firms will respond to this development by building more plants. This expands the productive capacity of the economy and causes, given competitive pressures, firms to lower their sales prices in an attempt to gain market share. Their profit margins, though, should remain relatively stable because the drop in their output prices is matched by a drop in their unit costs of production.

Note that all firms are lowering to varying degrees their output price because of this process. Consequently, the price level, an average of firms’ output prices, will also fall. This spreads the benefits of the productivity gains to all workers through higher real wages. And with these higher real wages workers can provide the demand needed for full employment.

Now imagine central banks respond to this productivity-driven deflation by easing monetary policy, as they would under inflation targeting. Sales prices are stabilized, but given sticky input prices like wages this action also leads to expanded profit margins. So instead of allowing the productivity gains to be shared with labor through a gently falling price level, monetary policy has instead served to increase the share of income going  to capital. 

This, in my view, explains a meaningful amount--though not all--of the growth in capital income since the mid-1990s. And my fear is that in the second machine age with rapid productivity growth this trend will worsen. Below is a figure from a recent paper of mine that lends support to this interpretation:

Now I want to be clear. I am not advocating the malign deflation that comes form a collapse of aggregate demand, as seen in the 1930s. What I am talking about is allowing productivity shocks to be gently reflected in the price level while stabilizing aggregate demand growth. This is a benign form of deflation and yes, it has happened.

Under this kind of deflation, the standard problems associated with deflation--the zero lower bound (ZLB), financial intermediation, and real debt burdens--are less of an issue. The higher productivity growth implies a higher real interest rate that should counter the downward pressure on the nominal interest rate and therefore minimize the chance of hitting the ZLB. Financial intermediation should not be adversely affected either, since the burden of any unanticipated increase in real debt coming from the benign deflation would be offset by a corresponding unanticipated increase in real incomes. Collateral values, meanwhile, should not decline but increase given expectations of higher future earnings from the productivity growth. 

By keeping output price growth stable, inflation targeting inadvertently contributes to the rising share of income going to capital in periods of rising productivity. So what kind of monetary policy would stabilize aggregate demand growth and allow changes in productivity growth to be reflected in the price level and thus in real wages? The answer is a NGDP target. Under this rule, the Fed would aim to stabilize the growth of total dollar spending (or equivalently nominal income) and quit worrying about changes in inflation. Some like George Selgin would further focus the Fed target explicitly on the expected growth of nominal wages. Either way, the Fed would let productivity be reflected in the price level.

So a partial solution to the growing income inequality between labor and capital income is to have monetary policy adopt a NGDP target of some kind.  For those who have little faith in monetary policy hitting a NGDP target this approach can be operationalized with the help of fiscal policy. 

¹Since output prices have been stabilized, workers are still getting the real wage they were expecting ex-ante. Hence, there is not the same motivation to ask for a wage increase allowing this condition to persist for awhile. Workers, however, will begin to grumble as they see the increased share of income going to capital as is now the case.

Was Monetary Policy Loose During the Housing Boom?

Did the Fed's set its policy interest rate rate below the market-clearing or 'natural' interest rate level in the early-to-mid 2000s? Or did it simply lower its policy interest rate down to a depressed natural interest rate level during this time? The answers to these questions determine whether U.S. monetary policy was loose during the housing boom. 

John Taylor believes the Fed pushed interest rates below their natural interest rate level. He views this departure from a neutral stance as a key contributor to the housing boom. Ben Bernanke and Larry Summers believe otherwise. They see the Fed simply doing its job back then by adjusting its policy rate down to a low natural interest rate level. Bernanke believes the natural interest rate level was low because of a saving glut while Summers holds that its was depressed because of secular stagnation. Either way, both individuals do not blame the Fed for any role the low interest rates played in fostering the housing boom. The Fed''s lowering of interest rates was simply an endogenous response.

George Selgin, Berrak Bahadir, and I recently published an article that lends support to John Taylor's view of Fed policy during this time. It received some pushback from Scott Sumner who is sympathetic to both the saving glut and secular stagnation views. At the same time, Tony Yates provided a critique of John Taylor's argument on the financial crisis that was heartily endorsed by Paul Krugman. So the debate over the Fed policy during this period continues.

What I want to do here is to step back from this debate and review what I see as the key economic developments that affected U.S. interest rates at this time. Then, given these considerations, I will jump back into the debate and ask whether Fed policy pushed interest rates in the same direction as that implied by these developments.

The key developments as I see them are threefold: a falling term premiums, a spate of large positive supply shocks, and the emergence of a monetary superpower. Let us consider each one in turn.

I. Falling Term Premiums on Long-Term Treasuries

The term premium is the extra compensations investors require for the risk of holding a long-term treasury bond versus a sequence of short-term treasury bills over the same period. The term premium had been declining since the early 1980s and therefore put downward pressure on long-term interest rates. This development can be seen in the figure below which is created using the Adrian, Crump, and Moench (2013) data. (For more on this data see here.)

The decline has been attributed to several factors. First, there was a decline in inflation volatility and an overall improvement in macroeconomic stability during this time that made investors less risk averse to holding long-term bonds. They therefore demanded less compensation. Second, regulatory and accounting changes for certain firms increased their demand for treasury securities relative to their supply. This further reduced the term premium. Third, globalization was taking off, but without a concurrent deepening of financial markets in many of the affected countries. That meant that global income was growing faster than the world's ability to produce safe assets. Consequently, many developing countries started turning to the United States for safe assets. This further depressed the term premium and is the basis for Bernanke's saving glut theory.

A close look at the above figure shows this term premium decline intensified in 2003, falling about 1.4 percentage points over the next two years. This happened right during the time the Fed pushed its policy rate to record-low levels. This, then, appears to support the endogenous view of the low policy rates argued by Bernanke and Summers.

However, this conclusion needs to be tempered. For the next two developments discussed below suggest that a sizable portion of the declining term premium at this time may have been an endogenous response to the Fed's low interest rates policy during that time. 

II. A Spate of Large Positive Supply Shocks

The second important development is that the global economy got buffeted with a series of large positive supply shocks from the  opening up of Asia--especially China and India--and the rapid technology innovations that reached a crescendo in the early-to-mid 2000s. Global growth accelerated because of these developments as seen in the figure below:

The opening up of Asia significantly increased the world's labor supply while the technology gains increased productivity growth. The uptick in productivity growth, which peaked between 2002 and 2004, was widely discussed in the early 2000s and raised long-run expected productivity growth at the time. This can be seen in the figure below which shows a consensus forecast of annual average productivity growth over a ten year horizon:

Note that the rise in the labor force and productivity growth rates both raised the expected return to capital. The faster productivity growth also implied higher expected household incomes. These developments, in turn, should have lead to less saving and more borrowing by firms and households and put upward pressure on the natural interest rate. Interest rates, in short, should have been rising given these large positive supply shocks during this time. 

III. Emergence of a Muscle-Flexing Monetary Superpower 

The third development is that in the decade leading up to the financial crisis that the Fed became a monetary superpower that could flex its muscles. It  controlled the world's main reserve currency and many emerging markets were formally or informally pegged to dollar. Thus, its monetary policy got exported across much of the globe, a point acknowledged by Fed chair Janet Yellen. This meant that the other two monetary powers, the ECB and the Bank of Japan, were mindful of U.S. monetary policy lest their currencies became too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy got exported to some degree to Japan and the Euro area as well. Chris Crowe and I provide formal evidence for this view here as does Colin Gray here.

Now let's tie all these points together and see what it says about the Fed's role in the housing boom. Let's begin by noting that when the large positive supply shocks buffeted the global economy they created disinflationary pressures that bothered Fed officials. They did not like the falling inflation. So Fed officials responded by easing monetary policy. Recall, though, that the supply shocks were raising the return to capital and expected income growth and therefore putting upward pressure on the natural interest rate. The Fed, consequently, was pushing down its policy rate at the very time the natural interest rate was rising. Monetary policy was inadvertently being loosened.

This error was compounded by the fact that the Fed was a monetary superpower. The Fed's easing in the early-to-mid 2000s meant the dollar-pegging countries were forced to buy more dollars. These economies then used the dollars to buy up U.S. treasuries and GSE securities. This increased the demand for safe assets and ostensibly reinforced the push to transform risky private assets into AAA assets. To the extent  the ECB and the Bank of Japan also responded to U.S. monetary policy, they too were acquiring foreign reserves and channeling  credit back to the U.S. economy.  Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.  The 2003-2005 decline in the term premium, in other words, was to some extent an endogenous response to the easing of Fed policy during this time.

The figure below highlights this relationship for the period 1997-2006. It comes from my work with Chris Crowe and shows that almost 50% of the foreign reserve buildup was tied to deviations of the federal funds rate from the Taylor Rule. Colin Gray estimates several regression models on this relationship and finds that for every 1% point deviation of the federal funds rate below the Taylor Rule, foreign reserves grew by $11.5 billion. The Fed, therefore, was putting downward pressure on interest rates not only directly via the setting of its federal funds rate target, but also by raising the amount of credit channeled into the long-term U.S. securities.

Given these points, I think it is reasonable to conclude the Fed contributed to the housing boom. I hope they give Scott, Tony, and Paul something to think about.

Let me be clear about my views Even though the Fed kept its policy rate below the natural rate for a good part of the housing boom period, the opposite happened after the crash due to the ZLB. This is a point Ramesh Ponnuru and I made in a recent National Review article. So unlike some observes who see the Fed as being eternally loose, I take a different view: the Fed was too loose during the boom and too tight during the bust. 

Update: There are multiple measures of the output gap that show the U.S. economy overheating during this time. Below is a figure from this article that compares the real-time and final measures of the U.S. output gap. Everyone shows ex-post an overheating economy during the housing boom:

It Takes A Regime Shift to Raise an Economy

This week we learned that Ben Bernanke does not view NGDP level targeting, price level targeting, or a higher inflation target as the best way to deal with the zero lower bound (ZLB) problem. Now I believe the "what to do at the ZLB" debate is becoming moot as the U.S. economy improves, but it is interesting to consider Bernanke's thoughts on these alternative approaches to monetary policy. Here he is questioning their usefulness at the ZLB relative to his preferred approach:

The second possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target. Suggestions that have been made include raising the inflation target, targeting the price level, or targeting some function of nominal GDP... a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy.

So Bernanke wants the Fed to keep its inflation target of 2% and complement it with more aggressive use of fiscal policy when up against the ZLB. It sounds reasonable, a more balanced mix of monetary and fiscal policy. What could possibly go wrong? A lot, actually, if you believe this approach would have generated substantially greater aggregate demand growth over the past six years.

Here is why. Fiscal policy can only create aggregate demand growth up to the point it pushes inflation to the Fed's 2% target. The Fed's preferred inflation measure, the PCE deflator, averaged 1.4% since 2009. That means fiscal policy would have had 60 basis points on average with which to work over the past six years in closing the output gap. Do we really think that would be enough for the level of aggregate demand shortfall experienced over this time?

What was needed was a monetary policy regime shift, one that would have allowed, if needed¹, a permanent increases in the non-sterilized portion of the monetary base to spur rapid growth in total dollar spending. It was never going to happen with a 2% inflation target. Imagine, for example,  the U.S. Treasury Department sent $5000 checks to every household. As individuals began to spend their new money inflation would start rising, but it could only rise by 60 basis points before the Fed started tightening policy. The 'helicopter drop' would be stillborn.

As a counterexample, consider a regime shift to a price level target. This is not my preferred approach, but it illustrates well that the type of monetary regime needed to restore full employment over the past six years was far from a 2% inflation target. Here is how I describe it from an earlier post:

One [such] monetary regime change would be a price level target that returns the PCE to its pre-crisis trend path. To return the PCE to its targeted path would require a temporary burst of higher-than-normal inflation. The expectation of and realization of this inflation burst would be the catalyst that spurred robust aggregate demand growth.

Now let us pretend the Fed actually implemented a price level target back in 2010 when it began QE2. Specifically, imagine the Fed had made QE2 conditional on the PCE returning to its 2002-2008 trend path. The figure below shows this scenario with three different paths back to the price level target. Note that each path represents differing rates--5%, 4%, and 3%--of 'catch-up' inflation and for each path there is a significant amount of time--16 months, 26 months, and 49 plus months--involved to catch up to trend.

What this illustrates is that to get the kind of robust aggregate demand growth needed to close the output gap back in 2010, there needed to be a sustained (but ultimately temporary) period of higher-than-normal inflation. Doing more fiscal policy to squeeze out the last 60 basis points of the Fed's 2% inflation target would not cut it...it would be tinkering on the margins. If fiscal policy really wanted to close a large output gap at the ZLB it too needs the support of monetary regime change.

Again, I think the ZLB debate is becoming moot for the U.S. economy. But this discussion highlights why I believe greater use of fiscal policy over the past few years would not have heralded a stronger recovery. The U.S. economy has been chained to a monetary regime that while effective in anchoring inflation expectations also served to stymie a full-throttle recovery. If you want fiscal policy to work, you have to have a monetary regime that works. This was the core issue, not the degree of monetary-fiscal policy mix.

So yes, a regime shift was needed over the past six years. I would like to have seen a shift to a NGDP level target. Not only would it addressed the ZLB problem, but it also deals with the knowledge problem, financial stability, and supply shocks better than a price level or higher inflation target. For an accessible discussion of these points see my piece with Ramesh Ponnuru on the right goal for central banks. For a NGDP proposal that utilizes a monetary-fiscal mix see this post.

¹A permanent increase in the monetary base may not be necessary if the the regime shift causes the velocity of money to sufficiently change. The actual expansion may not be needed or be very small if this commitment is credible. To see this, imagine the Fed targets the growth path of nominal GDP (i.e. a NGDP level target). If the public believes the Fed will permanently expand the monetary base if NGDP is below its targeted growth path, then the public would have little reason to increase their holdings of liquid assets when shocks hit the economy. That is, if the public believes the Fed will prevent the shock from derailing total dollar spending they would not feel the need to rebalance their portfolios toward safe, liquid assets. This, in turn, would keep velocity from dropping and therefore require minimal permanent monetary injections by the Fed to hit its NGDP level target.