In late August, economists, scholars, and central bankers from across the world gathered in Jackson Hole, Wyoming to make sense of current economic indicators and to plot a path forward for monetary and economic policy in both the United States and the rest of the world.
Speaking at this summit was Janet Yellen, the new chair of the Federal Reserve, who reflected on the state of the labor market and how the bank may revise its current policy of monetary stimulus through both historically low interest rates and the purchasing of bonds and other securities in order to add liquidity — money — to the market.
In her opening remarks, Mrs. Yellen sounded an optimistic note on the current state of the labor market, noting that in 2014 the economy added 230,000 jobs per month — up from 190,000 per month in 2012 and 2013.
However, she concluded that “[f]ive years after the end of the recession, the labor market has yet to fully recover.”
Yellen’s assessments are backed up by troves of economic data which support the conclusion that the labor market is fundamentally different from its pre-recession form.
Some causes of this malaise are captured by the theory of “secular stagnation,” which points to an aging population, a mismatch between current and necessary skills in the work force, and unrealized potential in economic output as causes of a slow economic recovery.
Nevertheless, the Federal Reserve believes it can play some role in inducing economic activity.
One means of such encouragement is by keeping the federal funds rate (the rate at which banks lend to each other and to the Federal Reserve itself) between 0 and 0.25 percent. This low interest rate is not only intended to encourage banks to make loans to businesses and home buyers and thus stimulate job growth in various sectors, but also to encourage investment in general.
On August 25, 2014, the S&P 500 reached 2,000 points for the first time — a sign that easy money has lifted stock values and stimulated investment.
Since 2008, the Federal Reserve has also purchased mortgage-backed securities and treasury bills in order to add money to the money supply. This method of monetary stimulus, known as “quantitative easing,” is in its third iteration and is called QE3 for short.
Pumping money into the system in order to stimulate economic activity and reduce unemployment while also keeping inflation in check by raising interest rates at the proper moment to curb the money supply represents the “dual mandate” of the Federal Reserve, which it was assigned by an act of Congress in 1977.
Yellen, who is characterized as “dovish” on inflation because of her willingness to inject more money into the system in order to reduce unemployment, suggestedthat the time to raise interest rates had not yet come, even though the unemployment rate has fallen to 6.2 percent. This is below the rate of 6.5 percent, which, back in March 2014, the Fed indicated would be the point at which it might initiate a rate hike.
Speaking at the Jackson Hole summit, Yellen cautioned that,
“Tightening monetary policy as soon as inflation moves back toward 2 percent might, in this case, prevent labor markets from recovering fully and so would not be consistent with the dual mandate.”
In other words, Yellen announced that an inflation figure at or above 2 percent would be a tolerable side effect of further reducing unemployment.
However, there is dissent within the Federal Reserve about how to steer monetary policy in the near and short term.
For instance, Kansas City Federal Reserve President Esther George and his colleague at the helm of the regional bank in Dallas, Richard Fisher, have stated that the market is prepared for a marginal increase in the federal funds rate.
Moreover, Philadelphia Federal Reserve President Charles Plosser dissented from the Federal Open Market Committee’s (FOMC) July statement that offered a wait-and-see approach to raising interest rates after the bond-buying program eventually comes to an end, likely sometime this fall.
In this July 30 meeting, the Fed announced a reduction in its quantitative easing program, which has fallen to its current level of $25 billion per month from a previous high at $85 billion per month.
Plosser, critical of Yellen’s indecisiveness and ambiguity, is in favor of a more transparent, clearly defined set of criteria that should guide the Fed’s decision-making process and reduce uncertainty and volatility in the financial sector.
While some market-watchers have fretted about the possibility of rapid inflation due to low interest rates and quantitative easing, economists generally agree that numerous factors have kept inflation in check at a comfortable rate of 2 percent.
One such factor is that the low cost of borrowing and easy access to cash has not necessarily increased the flow of money: one year after QE3 began in September 2012, only $80 billion of the $800 billion added to banks’ reserves entered the economy’s bloodstream. Currently, more than $2 trillion are parked on the sidelines in reserve.
Another explanation for low inflation is what some economists call “leakage”: some capital leaves for overseas and thus exits the American economy proper, with much investment flowing into emerging markets in particular rather than staying in the United States.
However, while inflation may currently pose no immediate risk, market-watchers voice other criticisms of the Fed’s current policy.
For instance, Jaime Caruana, head of the Bank of International Settlements (BIS) — the so-called “bank of central banks” located in Switzerland — warned that the leakage caused by quantitative easing in both the U.S. and Europe has created financial instability in countries like India, Turkey, and China, which have been awash in trillions of dollars of foreign money.
These countries fear that changes in the Fed’s policy, such as the reduction in the bond-purchasing program (called the “taper”), could trigger a repatriation of American dollars seeking higher yields and might thus lead to a scarcity of dollars in these countries, as well as domestic inflation and high borrowing costs for dollars needed to purchase imports denominated in American currency.
Some investors are also critical of the Fed’s easy money policy because of the possibilities of creating perverse incentives and promoting the inefficient allocation of capital. For instance, economists fear that low interest rates could lead to the creation of asset bubbles like the one in the real estate market that burst in 2007 and precipitated the financial crisis in 2008.
Moreover, investors worry that the Fed, in the words of one analyst, is “spending $4 trillion [in money lent to it from other banks at the 0.25 percent federal funds rate] to prop up investment errors that, if allowed to reach their natural level, would force a reorientation of capital to higher, more economically enhancing uses.”
Progressives, on the other hand, lament that the Fed-led boom in the stock market leaves those who have a major stake in the stock market — primarily the wealthy — to profit the most from its meteoric rise.
Members of the left-wing Center for Popular Democracy, a Brooklyn-based organization that attended the conference in Jackson Hole to express concern over the current state of the economy, wore t-shirts emblazoned with the question, “What recovery?”
As Mrs. Yellen and her fellow members of the Fed continue to watch changes in the American labor market, including unemployment and numerous other indicators, it is predicted that quantitative easing will continue to be phased out and that interest rates will rise slightly once market conditions improve – whenever that may be.