There were few surprises in the Federal Reserve’s decision on interest rates on Wednesday. As had been widely expected, the central bank decided to increase the Federal Funds rate by a quarter point to a new range of 1.75% – 2%. This was the seventh rate hike since December 2015, and the second time this year. The Fed also indicated that there would be two more increases before the end of the year, and another three increases in 2019. If the Fed does implement the tightening process as expected, that would put the the key interest rate at between 3% and 3.25% by the end of 2019.
Chairman Jerome Powell put on a brave face despite the uncertainties he currently encounters. Compared with the latest U3 unemployment rate of 3.8% in May, the Fed and his colleagues assume that the rate will drop to 3.6% this year. And since the Fed’s assumed long-run sustainable unemployment rate is 4.5%, we are experiencing a situation that cannot be maintained without a concomitant rise in the inflation rate. To forestall a sharp pick up in prices and stop inflation in its tracks the Fed needed to tighten further to prevent too sharp a contraction of the economy later.
There are two problems with the Fed’s calculations. First, there is no precise means of measuring the level of the sustainable unemployment rate. Estimates of this long-run level range all the way from 4.5% to 6%, and may not take account of changes in technology that have improved worker productivity and enabled a lower level of joblessness to be sustained over time without an acceleration in inflation. And if the Fed were to increase rates excessively without having a proper measure of the slack in the labor market, the result would be a curtailment of aggregate demand, pushing the economy into recession.
Second, the lower unemployment over the past couple of months has been accompanied by a drop in the labor force participation rate for 25 – 54 olds — the prime working-age group unaffected by the aging of the US population. This rate has fallen from 82.2% in March to 82% in April, and further to 81.9% in May. All these figures are substantially lower than the participation levels for this age group before the onset of the Grand Recession. Had it not been for the fall in the participation rate, the unemployment would still be north of 4%. To increase interest rates without being sure of the state of the labor market invites trouble — it risks slowing the economy way beyond the requirement of the Fed’s mandate to maintain a stable inflation rate.
By indicating that he would hold press conferences after every Fed meeting beginning in January 2019, the Fed Chair has probably increased the anxiety of investors every time the policy makers meet. Rather than make investment decisions based on fundamentals, a higher frequency of the press conferences would increase the dominance of the Fed in financial markets, boosting volatility in the process.
The US Treasury market expressed its doubts about the Fed decision as the spread between the yields on the two- and 10-year securities dropped to a new low of less than 39 basis points on Wednesday. The spread was last this narrow on August 29, 2007, a few months before the recession began. With the yield on two-year securities closely tied to the Federal Funds rate, the Fed’s threat to increase the rate two more times this year threatens to invert the yield curve over the coming months.
Fed Chair Powell’s suggested interest rate path could have us staring at a recession by late-2019.