Last week’s statements from key Federal Reserve officials, including Chair Janet Yellen, emphasized their intent to raise interest rates more quickly this year than previously. Indeed, whereas 2015 and 2016 each witnessed just a single rate hike, in both cases coming at the very end of the year, Chair Yellen hinted strongly that the first of several rate increases planned for 2017 could come as soon as March 15, the date of the Fed’s next meeting.
A close look the recent data supports Chair Yellen’s view that the economic outlook has improved and that further monetary tightening may soon be needed to prevent inflation from overshooting its two percent target. All of this is good news: more than anything else, it shows that U.S. monetary policy, like the economy as a whole, is finally working its way back to normal. At the same time, however, other indicators show that monetary policy has not been as accommodative as widely believed. These observations caution against moving interest rates higher by too much, too soon.
The table below compares readings on six key economic indicators today, at the beginning of 2017, to their values at the start of each of the past several years. Its first two columns provide evidence of continuing improvement of the American labor market and the economy as a whole. The unemployment rate fell below 5 percent at the beginning of last year, and has remained low and stable since then. Meanwhile, average monthly growth in nonfarm payroll employment continues to be robust. True, the pace of job creation has slowed somewhat since 2015, but this modest deceleration most likely reflects another positive development that, as many workers have found new jobs, the pool of those still looking has diminished.
As noted in a prior column, Federal Reserve officials often use measures of employment and unemployment not only to gauge the health of the economy but also as a signal of underlying inflationary pressures. Behind this view is the idea that a Phillips curve trade-off makes inflation more likely to rise when unemployment is falling. In the past, however, the Phillips curve has not always been a reliable guide for policymaking. Notice how, for example, the U.S. economy experienced declining inflation, even as unemployment was falling as well, between 2014 and 2015.
Problems with the Phillips curve make it desirable to look more directly at the behavior of inflation itself. Today, in fact, the Fed’s preferred measure of inflation, based on the price index for personal consumption expenditures, has come very close to matching the central bank’s long-run target of 2 percent. Just as some of the slowdown in PCE inflation during 2015 was the result of sharply falling energy prices, however, some of the recent snapback might be attributed to the partial reversal of those earlier declines. Nevertheless, the “core” measure of PCE inflation that strips out the direct effects of volatility in food and energy prices has also increased noticeably since 2015 and appears to be converging to the 2 percent target. Based on these data, therefore, another modest interest rate increase at the Fed’s March meeting seems prudent, as a way of helping to insure that inflation does not move too much higher, overshooting its long-run target and requiring more aggressive actions later.
Given the lags with which monetary policy affects inflation, it is also worth asking whether the stimulus already applied by years of extremely low interest rates is likely to put additional upward pressure on prices in 2017 or beyond. The table’s last two columns provide data to address this question and deliver a mixed message. Reassuringly, they show that growth in the Divisia M2 measure of the money supply has accelerated somewhat, even as the Fed moved gradually to raise interest rates first in December 2015 and again in December 2016. On the other hand, monetary velocity continues to trend downward, so that this increase in money growth has not translated into a sustained pickup in nominal spending. In fact, today’s 3.5 percent annual rate of nominal GDP growth is consistent with inflation of only 1.5 percent, assuming long-run real GDP growth of 2 percent.
Thus, from a quantity-theoretic perspective that uses nominal income PY to assess whether growth in the money supply M has been sufficient to offset movements in velocity V, monetary policy has not been nearly as accommodative as popularly believed. For now, the improving economy and, especially, the rebound in inflation make it sensible for the Fed to raise interest rates. But if, in particular, the recent trends towards faster M2 and nominal GDP growth were to reverse themselves in 2017, that would be a clear signal that the Fed needs to slow down and return to a more gradual path towards tighter policy.
Peter Ireland is a professor at Boston College and a member of the Shadow Open Market Committee.
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