In last week’s testimony before the Joint Economic Committee of Congress, Federal Reserve Chairman Jerome Powell applauded the U.S. economy’s continued strength. He also suggested that, after easing monetary policy three times this year, the Fed will hold interest rates at their present levels so long as the favorable outlook remains intact.
While the recent data that Chairman Powell reviewed confirm that recent rate cuts represent an appropriate policy response to surprises that have unfolded since the beginning of the year, the details of his testimony point to additional challenges that will confront the Fed as national elections approach in 2020. At the same time, Chairman Powell’s testimony also served to highlight the even greater economic policy challenges facing members of Congress themselves.
To evaluate Chairman Powell’s arguments, it helps to consider data on the same variables he mentioned in his testimony: real GDP growth, unemployment, and inflation. It helps even more to see how these recent data compare to what members of the Federal Open Market Committee (FOMC) expected when they prepared to meet in December 2018. At that final meeting last year, the FOMC raised interest rates; the committee has reversed course since then. What fundamental economic developments justify this change in policy?
Projection materials from the December 2018 meeting reveal that, even as FOMC members were voting to raise rates late last year, their median projection for real GDP growth in 2019 was 2.3%. In fact, annualized real GDP growth came in at 3.1% in the first quarter of 2019, 2% in the second, and 1.9% in the third. Averaging these numbers yields a figure—2.3%—exactly equal to the FOMC forecast!
The same projection materials show that the FOMC expected the unemployment rate, which stood at 3.9% last December, to decline to 3.5% in 2019. Today, the unemployment rate is 3.6%—again, almost exactly equal to the forecast. Although macroeconomic forecasting is notoriously difficulty, Fed officials appear to have anticipated with remarkable foresight both the gradual slowdown in GDP growth and the continued strength and resiliency of the American labor market in 2019.
Instead, FOMC projections point to inflation as a major source of surprises. At their meeting last December, the committee raised interest rates with the expectation that their preferred measures of inflation, one based on the price index for personal consumption expenditures (PCE) and the other based on the “core” PCE excluding food and energy, would rise to 1.9% and 2.0% this year. But, for the first nine months of 2019, PCE and core PCE inflation have run at annual rates of just 1.4% and 1.5%. These differences are quite significant: by either measure, inflation has been half a percentage point slower than anticipated.
How should the Fed have responded to this surprising shortfall in inflation? Many mainstream macroeconomists believe that Federal Reserve interest rate policy should follow the “Taylor principle.” Named after Stanford economist John Taylor, the Taylor principle dictates that the Fed adjust its policy rates more than proportionally in response to movements in inflation. To see the rationale, suppose that inflation rises one percentage point above the Fed’s long-run target. To bring inflation back down, the Fed must tighten monetary policy by raising interest rates in “real,” or inflation-adjusted, terms; this requires “nominal” policy rates to rise by more than one percentage point. Conversely, when inflation falls one percentage point below target, the Fed must lower its policy rates by more than 1% to generate the appropriate monetary easing.
The Taylor principle is reflected in the design of John Taylor’s own interest rate rule, which calls on the Fed to adjust its policy rates by an amount equal to 1.5 times the underlying change in inflation. Using the Taylor rule, therefore, the FOMC’s decision to lower interest rates in three steps this year, by a total of 0.75 percentage points, appears fully justified by the fact that the inflation has been 0.5 percentage points slower than expected.
In his testimony, Chairman Powell chose, instead, to explain the recent interest rate adjustments with reference to a number of additional factors, including “weakness in global growth” and “trade developments” as well as “muted inflation.” It would be far better if he, and other Fed officials, described their policy actions with reference to changing forecasts for real GDP growth, unemployment, and inflation alone, ideally based on a specific policy rule like Taylor’s.
The advantages of such a rule-based approach can be seen most vividly when looking ahead to the elections of 2020. If a shifting outlook for economic growth or, especially, inflation, requires further adjustments to interest rates in 2020, Chairman Powell and his FOMC colleagues must be prepared to make those adjustments without appearing to favor either incumbents or challengers in the elections. The FOMC has always resisted calls to adopt a specific monetary policy rule but, by doing so, they could assure the public that the policy actions it takes represent its continued, systematic response to economic developments and are in no way politically motivated. Thus, while Chairman Powell’s testimony does successfully rationalize the Fed’s policy actions in 2019, it unfortunately leaves the Fed open to attack in 2020.
The biggest and most important economic policy challenges in 2020, however, may be those faced by Congress itself. At the conclusion of last week’s hearing, Sen. Mike Lee (R., Utah), as chairman of the Joint Economic Committee, concurred with Chairman Powell’s assessment that “we are in the middle of some pretty strong economic activity” and asked what “policies should we pursue to keep that going?” In response, Chairman Powell responded:
The thing to focus on ... are the longer-run issues that we face, particularly around labor force participation and growth .... It’s about the potential growth of the United States. We are seeing now how important it is and how good it is to have a long expansion with a lot of growth and how it benefits people across the income spectrum .... In the longer run, the things we need to address are labor force participation and productivity .... Those are the things that are going to matter for our children and grandchildren ... to keep the U.S. sustainable longer-term growth rate as high as it can be going forward.
From the video documenting this final exchange, it appears that most of the committee members had already left the room and did not hear Chairman Powell’s message. That is a real shame. Members of Congress need to ask themselves whether the policies being discussed on the campaign trial—many of which call for higher taxes and more regulation—are likely to strengthen or weaken the incentives for many Americans to join the labor force. They should consider, as well, whether their own satisfaction from taxing those who are already wealthy today is worth the costs it will impose by discouraging saving and entrepreneurial activity by those who strive to become wealthy in the future.
The Fed makes its best contribution to general prosperity when it conducts monetary policy in a systematic, rule-like way to maintain an environment of stable prices. But Congress needs to join in as well, by allowing the free market to do what it does best: providing incentives for labor force participation and productivity growth that will keep living standards for all Americans on a robust, upward path.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
Photo: Alex Wong / Getty Images