Federal Reserve Chair Janet Yellen acknowledged the U.S. central bank could be closer to raising interest rates than it expected earlier this year, reflecting a surprisingly quick pace of hiring.
Ms. Yellen’s observation was equivocal: She said it also was possible that the economy could lose momentum, forcing the Fed to delay lifting its benchmark rate from zero. However, her willingness to consider the possibility that the Fed’s return to a more typical policy setting is ahead of schedule represents a subtle shift that likely will catch Wall Street’s attention.
“If progress in the labour market continues to be more rapid than anticipated by the [Fed’s policy committee] or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the committee currently expects and could be more rapid thereafter,” Ms. Yellen said in prepared remarks Friday at the Kansas City Fed’s economics conference in Wyoming’s Grand Teton National Park.
Ms. Yellen’s comments echo the minutes of the Fed’s end-of-July policy meeting, which showed a split on the committee about the strength of the economy. The Fed opted to leave its aggressive stimulus program in place last month in a nine-to-one vote. However, concern that the Fed is at risk of losing its grip on inflation was wider spread than a single dissenter. The minutes noted that “many” officials sensed the Fed would need to raise the fed funds rate sooner than planned.
It’s a delicate decision. Economic growth is good, but perhaps not great. That is tempting the Fed to keep borrowing costs lower for longer. By lifting its benchmark rate, the central bank will create a ripple effect that will raise the cost of business and household credit. Ideally, the Fed would do that gradually to avoid shocking borrowers who have grown used to extremely low interest rates. The risk is the Fed waits too long and is forced to raise borrowing costs quickly to snuff out inflation. Such a jolt could stall an economy that has proved fragile in the aftermath of the financial crisis.
The Fed sets policy to achieve “maximum” employment while keeping inflation at an annual rate of 2 per cent. Price increases remain contained, although various measures have been edging closer to the central bank’s target in recent months. The unemployment rate dropped to 6.2 per cent in July, roughly the level the Fed’s policy committee expected at the end of the year, not the middle of the summer. Payrolls have increased 230,000 a month, on average, in 2014, compared with an average monthly gain of 190,000 over the previous two years.
“Over the past year, the unemployment rate has fallen considerably, and at a surprisingly rapid pace,” Ms. Yellen said. “These developments are encouraging, but it speaks to the depth of the damage that, five years after the end of the recession, the labour market has yet to fully recover.”
Ms. Yellen has made no secret of the fact that she doesn’t entirely trust the signal being sent by the standard measures of employment.
More granular indicators tell a different story. The inclusion of part-time workers who would like full-time work are included with the unemployed shows a high level of underemployment. The rate was 12.2 per cent in July, down from 13.9 per cent a year earlier, but elevated compared with its precrisis norm: The rate was never higher than 10 per cent between the start of 2004 and the spring of 2008. The number of long-term unemployed also is elevated, and the participation rate is at its lowest level in decades. Wage growth is muted.
These measures suggest the U.S. economy still has room to grow. The question the Fed is grappling with is: How much? Ms. Yellen devoted most of her speech to describing the analysis she and her colleagues are applying to try to understand whether more stimulus would turn part-time work into full-time positions or pull discouraged workers off the sidelines. The Fed chair did little to hide the fact that that there are no clear answers.
Take wages. They are growing at about the same rate as inflation, suggesting a glut of potential workers is restraining what employed people can demand from their bosses. Unless, as Ms. Yellen pointed out in her speech, something else is going on. She called it “pent-up wage deflation.” During the crisis, when profits cratered, employers still struggled to cut wages. That hurt the bottom line, and companies may now be trying to win some of that back by delaying pay raises. The problem for the Fed is that once employers relent, inflation could be unleashed. That could force policy makers to raise interest rates quickly, which would risk hurting the economy.
“Our assessments of the degree of slack must be based on a wide range of variables and will require difficult judgments about the cyclical and structural influences in the labour market,” Ms. Yellen said.