Harvard Professor Martin Feldstein: Why the Fed Will Go Faster

The US Federal Reserve has emphasized that its monetary policy will be determined by what economic indicators show. But it would require some extremely unlikely data to change the Fed’s implicit plan to end its purchases of long-term assets (so-called quantitative easing) in October 2014 and to start raising the federal funds rate from its current near-zero level sometime in the first half of 2015.

The financial markets are obsessed with anticipating whether rates will rise in March or June. Although my own best guess is that the Fed will start to raise rates in March, the starting date is less important than the pace of the rate increase and where the rate will be by the end of 2015.

There is a substantial range of views among the members of the rate-setting Federal Open Market Committee. The midpoint of the opinions recorded at most recent FOMC meeting implies a federal funds rate of 1.25-1.5% at the end of 2015. Even by the end of 2016, the midpoint of the range is less than 3%.

In my judgment, such rates would be too low. At a time when inflation is already close to 2% or higher, depending on how it is measured, the real federal funds rate would be at zero at the end of 2015. Instead of ensuring price stability, monetary policy would be feeding a further increase in the inflation rate.

Although it is possible to argue about the precise appropriate level of the fed funds rate, the Fed’s own analysis points to a long-term rate of about 4% when the long-term inflation rate is 2%. The most recent value of the consumer price index was up 1.7% year on year, and the 12-month figure would have been even higher but for the anomalous decline in the most recent month. In the second quarter of this year, the annualized inflation rate was 4%.

The Fed prefers to measure inflation by the price index for personal consumption expenditure. Its relaxed attitude about inflation reflects its focus on the longer-term past, with PCE inflation at just 1.5% for the 12 months to August of this year, the same as the “core” PCE inflation rate, which excludes food and energy. But PCE inflation has also been rising, with the most recent quarterly value at 2.3% year on year in the April-June period.

So if price stability were the Fed’s only goal, the federal funds rate should now be close to 4%. The Fed’s rationale for continuing its ultra-easy monetary policy is that its “dual mandate” requires it to be concerned with employment as well. Its monthly statements emphasize that there is still “a significant underutilization of labor resources, ” reflecting not only the 6.1% unemployment rate, but also the millions of part-time employees seeking a full-time job and those who are not officially counted as unemployed because they are not actively looking for work.

The Fed is certainly correct that current labor-market conditions imply significant economic waste and personal hardship. But economists debate the extent to which these conditions reflect a cyclical demand shortfall or more structural problems that a monetary stimulus cannot remedy. Arecent study by a team of Fed economists concluded that nearly all of the current decline in the labor-force participation rate reflects the aging of the population and other structural causes.

Recent research also indicates that increases in demand that would cause a further reduction in the current unemployment rate would boost the inflation rate. An important study co-authored by Alan Krueger of Princeton University, who served as Chairman of President Obama’s Council of Economic Advisers until last year, showed that the inflation rate reflects the level of short-term unemployment (lasting less than six months), rather than the overall unemployment rate. Longer-term unemployment implies a waste of potential output and a source of personal suffering, but it does not have an impact on the rate of inflation.

Krueger’s analysis indicates that the rate of inflation begins to increase when the short-term unemployment rate falls to 4-4.5%. With short-term unemployment currently at 4.2%, the inflation rate is indeed rising, and Krueger’s research suggests that it will increase further in the months ahead.

Similar studies by Robert Gordon of Northwestern University and by Glenn Rudebusch and John Wiliams of the San Francisco Federal Reserve Bank point to the same conclusion about the role of short-term unemployment and the irrelevance of long-term unemployment in the inflation process. While not all researchers agree with this analysis, I think the evidence is strong enough to represent a warning to the Fed and to market participants.

Indeed, I would not be surprised by a continued rise in the inflation rate in 2015. In that case, the Fed is likely to raise the federal funds rate more rapidly and to a higher year-end level than its recent statements imply.