With the Federal Reserve just a stone's throw away from achieving its dual mandate, why does it persist with unprecedented monetary stimulus, arguing the need to maintain a $4 trillion balance sheet and suggesting the likely need to extend its artificially low policy rate far into the future, even when its mandate is fully achieved?
Is it because the Fed truly believes that such extreme monetary stimulus is the proper policy tool for further labor market improvements, including reducing long-duration unemployment, transitioning part-time workers into full-time jobs and increasing the labor force participation rate; or offsetting the still tight mortgage credit availability that stems largely from the government's financial policies, including those of Fannie and Freddie?
Or, based on the Fed's significant under-estimation of the bond market selloff in mid-2013 following then-Chairman Bernanke's mention that the Fed may eventually taper its QEIII asset purchases, does the Fed really fear that any rise in interest rates or stock market correction will sidetrack the economic expansion?
In reality, neither line of argument supports the Fed's current conduct of monetary policy. The lingering underperformance in select labor market indicators reflects largely evolving non-cyclical labor market characteristics and a host of non-monetary factors affecting labor supply and demand that are way beyond the scope of monetary policy, and best addressed by economic policies (tax, spending and regulatory) that are under the authority of Congress and the Administration. Nor can the Fed remedy constraints on mortgage credit that would boost housing activity.
Secondly, a rise in real rates reflecting improving economic conditions after five years of economic expansion is favorable and should not be shunned. Recent history shows clearly that during early stages of cyclical recovery or even during mid-expansion, economic performance is not harmed by a timely and normal rise in real rates.
Fed Chair Yellen appropriately describes the financial and emotional burdens of the long-term unemployed. But with the unemployment rate at 6.1% and clearly on a falling trajectory, the Fed should be emphasizing the need for Congress to develop programs that enhance work skills required now and for the future and facilitate labor mobility, and pursue policies that encourage businesses to expand and hire, and to address policies that inadvertently deter full-time work.
It is obvious and well known that the Fed's monetary policy is incapable of creating permanent jobs. History tells us that trying to do so risks high longer-run costs, not just higher inflation. Fed Chair Yellen is in a perfect position to advise Congress on the benefits of monetary policy but also its limitations in addressing specific labor market conditions that cannot be remedied by normal aggregate demand management.
Labor demand and supply issues are very complex. They involve micro and industry specific factors as well as broader effects stemming from the confluence of technological advances and the internationalization of labor markets. These are real challenges that must be addressed with the appropriate policy tools.
The Fed can learn many valuable lessons from its monetary policies during prior cycles. Among them, once recoveries gained traction following recessionary monetary stimulus, positive and rising real interest rates never sidetracked economic expansion.
Following the Fed's mid-expansion monetary tightening in 1994--widely considered the Fed's most successful disinflationary, soft-landing episode in its one-hundred year history in which the Fed hiked rates 3 percentage points, raising inflation-adjusted 10-year Treasury bond yields to 3.5% -- economic growth slowed for 2 quarters, and then reaccelerated, led by the interest sensitive sectors of the economy. The Fed's appropriately aggressive tightening paved the way for sustained low inflation and the robust economic performance of the second half of the 1990s.
During the prior cycle, the economy recovered robustly in 1983, driven by strong advances in both consumption and business investment spending, even though real interest rates were very high. In both of these cases, there were positive influences from the fiscal and regulatory policies that supported economic growth.
Presently, there is no reason for the Fed to fear rising real interest rates, and there is no reason why Congress and economic journalists should not ask the Fed to reconcile its fears with historic experiences.
Ironically, it was the Fed's efforts to constrain bond yields during the 2003-2006 period that generated unintended and costly consequences, including facilitating the housing and household debt bubble. The economy, labor markets, and the Fed itself are still paying the price of those distortions -- the excess household debt and housing stock and an unsustainably high number of construction jobs that covered up underlying structural weaknesses in the economy. Even now, there are 1.6 million fewer construction jobs from their peak, and many of those do not have transferable skills to other sectors.
The Fed is understating the distortions while extending the scope of monetary policy better served by other economic and regulatory policies. The Fed's awkward attempts at forward guidance and transparency, fueled by its misplaced fear of raising rates and misguided notion that labor market underperformance is cyclical and reflects insufficient demand, are a self-fulfilling distortion stemming from its overextended monetary stimulus. The full dimensions and magnitudes of the longer-run effects will not be known until the next cycle. That is an unacceptable cost relative to the vastly diminished benefits of the current policy thrust.
Mickey Levy is a member of the Shadow Open Market Committee.
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