On Thursday, the Federal Reserve’s Open Market committee voted to not raise interest rates just yet. The six year long period of near zero interest rates designed to support economic recovery from the 2008 financial disaster will remain in place at least until the next meeting of the Fed committee in late October. The move was hailed by union leaders and liberal economists. the New York Times quoted the president of the A.F.L.-C.I.O., Richard Trumka, “We are pleased that the Federal Reserve has kept interest rates unchanged. We know the economic recovery still has not reached working families, and even a small rate increase can have devastating effects on our economic stability.”
Economist Jared Bernstein, senior fellow at the Center on Budget and Policy Priorities in Washington, in support of the Fed move, said this doesn’t feel like an economy that needs a brake, and that Fed Chair Janet Yellen is mindful of the absence of full employment. Wage gains have been scarce and despite the 5.1 percent unemployment rate nationally, many workers have trouble finding full-time positions and many others are still on the sidelines not looking for work because prospects still look bleak to them.
The key sentence in the Fed’s press release on the decision not to raise interest rates reflects the concern over global economic conditions, namely the slowdown in China’s growth and weakness in European economies. In the Fed’s words, “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
The Federal Reserve has a complicated task in trying to follow its mandate to steer the economy towards maximum employment while maintaining price stability. The Fed interprets price stability as a rate of price inflation of 2 percent per year. Maximum employment then is an unemployment rate consistent with that rate of inflation. But recent inflation has been running significantly below that target rate and current signs are for further downward pressure on prices. This leaves room for the Fed to be cautious on interest rate increases at the moment.
The Fed’s task is not an easy one on several counts. First, the fiscal policy followed by the politicians on Capitol Hill in Washington reflected in federal budgeting, spending and taxing decisions have their own independent effects on inflation and unemployment. These can be unpredictable and work against any moves by the Federal Reserve. Second, unpredictable global economic events can have severe impacts on the U.S. economy. Third and most important, economic research has shown that while moves by the Fed to raise or lower interest rates affect the economy, they take time to work. And the time that they take to have an effect is unpredictable.
If the Fed wants interest rates to affect the economy, say six months from now because that is when it expects full employment to be a reality given the current pace and change of economic activity, when should it raise the interest rate? No one can say for sure. And if the Fed raises rates now, but it takes 9, 10 or 12 months for these rates to moderate the economy, we could be in full blown inflation by then, especially if Europe and China were to solve their economic problems much sooner than expected. Should that happen it could be too late to stop inflation without a severe engineered contraction in the economy. And no one wants to see that again. Especially those of us who lived through the Paul Volcker years of the fight against inflation.
But for now the current Federal Reserve chair and a majority of the Board of Governors think they have some room to wait to see if the pace of the economic recovery continues on course before they decide to raise interest rates.