So it’s come to this. The monetary policy gurus at the Federal Reserve have decided to reduce the size of the bank’s swollen $4 trillion balance sheet in a gradual process—initially $10 billion per month, rising steadily thereafter.
Economists at the Lindsey Group estimate it will take until 2023 to complete the process, unless conditions change. Fed policymakers are debating whether the six-year wind-down should begin in September or December.
This dance of the monetary angels on the head of a pin ignores some unpleasant truths. Long before the policy plays out there will be one, and perhaps two, new Fed chairs, a few twists and turns of fiscal policy, several share price paroxysms, completion of Britain’s exit from the clutches of the eurocracy, a show-down with North Korea, and a complete upheaval in America’s important auto industry as self-driving electric vehicles take over the market for new vehicles. To mention just a few “known unknowns.”
Predicting the difference in the effect on the real-world economy of initiating balance-sheet shrinkage in September rather than December, or vice versa, would seem to be a daunting task, even for Fed officials confident in their forecasting skills. To what purpose is unclear.
Faced with this barrage of changes, the Fed has to rely on theories that, to put it mildly, are not proving reliable. With the unemployment rate at 4.4 percent, there should be sharp upward pressure on wages. Except there isn’t. And rising inflation. Except there isn’t. And a federal government moving to tighten fiscal policy. Except it isn’t. With central banks planning to unwind their balance sheets, investors should be pessimistic about the outlook. Except that confidence is at high levels. One Fed critic, McGill University economics professor Reuven Brenner, writing in American Affairs, pours scorn on “policies . . . which wear the mask of science but on closer inspection turn out to be more akin to astrology.”
That’s a bit too harsh. After all, in the absence of some theory that explains the interactions of the rapidly moving forces beating on our complicated economy, the Fed has little choice but to be, as it describes itself, “data-driven.” And it is an understatement to say that the data are confusing.
Start with the labor market. The 4.4 percent unemployment rate would seem to be about as low as it can go. But only a bit more than half of Americans between the ages of 18 and 64 have full-time jobs; nearly 95 million people are simply not in the job market. Nicholas Eberstadt, a well-regarded demographer at the American Enterprise Institute, says that the labor force participation rate of men aged 25-to-54 is lower now than it was at the end of the Great Depression.
When I was teaching this stuff, 4.4 percent was considered “full employment,” a harbinger of future wage inflation. No longer. Wages seem stuck. In the late 1990s and mid-2000s, when unemployment was this low, wages rose at annual rate of about 4 percent. Today they seem to be rising at about half that rate.
My guess is that the sluggish wage performance is due to structural changes in the economy: reduced power of trade unions; increased competition from countries in which the daily wage is below our hourly wage rate; downward pressure exerted by immigrants, legal and illegal; replacement of higher-paying manufacturing jobs with relatively lower-paying jobs in the hospitality and healthcare sectors; failure of productivity to replicate the almost 2 percent average annual increases maintained between 1990 and 2010. These are the structural changes that are difficult-to-impossible for model builders to capture as they try to divine from data relating to the past what will happen in the future.
Which explains the current schism in the Fed boardroom, which now contains a large elephant called low inflation. This pachyderm is so large that it cannot be ignored by the monetary policy committee. One group argues that inflation, now running at an annual rate of 1.4 percent, as the Fed prefers to measure it, has failed to hit the bank’s 2 percent target because of one-off events: a price war in the mobile phone industry, a not-to-be-repeated decline in drug prices. That suggests plunging ahead with plans to couple shrinking the balance sheet with further increases in the key Fed funds interest rate. Sign Janet Yellen on to the group believing “idiosyncratic factors” should weigh heavily on policy decisions.
Dissenters argue that we are in a low-inflation period that will survive such idiosyncrasies. The auto industry is coming off years of record sales, and prices are likely to soften as dealers try to clear a build-up in inventories, to move the metal off showroom floors and into consumers’ garages, to use industry jargon. Perhaps because college tuitions have reached levels incommensurate with the value of the education provided—or perhaps because of the overhang of student debt—the rate of increase in education costs has halved, as has the increase in shelter costs. Commodity prices—nickel, copper, oil—are down from their peaks in mid-February, contrary to most forecasts, including those of Goldman Sachs. “How did we . . . get it so wrong?”, the firm’s analysts asked in a research note.
For now, the Fed is trying to engineer a soft landing by raising interest rates and allowing its balance sheet to shrink by not replacing bonds and mortgages as they mature. A soft landing has typically meant lowering inflation and slowing growth. But both are already at historically low levels. With both inflation and growth running at the meagre rates of 1.4 percent, driving them down further increases the odds that this tightening cycle, like several before it, will end in tears.
Unless it doesn’t.
