The stock market responded positively Wednesday to the Federal Reserve’s move to raise interest rates and plan for six more increases by year’s end. I wish I could share that enthusiasm. Instead, I fear, the economic projections of the Federal Open Market Committee (FOMC) represent a continuation of its wishful and delusional thinking of the recent past.
Start with the labor market. It is now tighter than at any point in history: The vacancy-to-unemployment ratio is in unprecedented territory, quits are at near-record levels and wage growth is still rising at 6 percent, having accelerated rapidly in the past few months. The FOMC expects further tightening, to a 3.5 percent unemployment rate, which it expects will be maintained through 2024.
Three years at 3.5 percent unemployment, something the country has not seen in about 60 years, is highly implausible. Indeed, the historical experience is that when unemployment is below 4 percent, there is a 70 percent chance of joblessness rising rapidly in the next two years as the economy goes into recession.
But that is not the central absurdity in the Fed forecast. The chief problem is the idea that a super-tight labor market will somehow coincide with rapidly slowing inflation. Even on the Fed’s optimistic accounting, a balanced economy requires 4 percent unemployment, meaning that it expects the labor market will remain abnormally tight over the next few years.
Data on vacancies and tightness reinforce the case that such conditions are inflationary, not disinflationary. Wages represent by far the largest component of costs. When they are rising so fast, what basis is there for supposing that inflation will slow to the 2 percent range foreseen by the Fed?
Focusing on the tightness of labor markets as a basis for forecasting inflation is firmly within progressive Keynesian tradition. Many economists look, as Milton Friedman and Paul Volcker did, to measures of money supply or projected government debt for guidance on inflation. These indicators are much more alarming.
A look at the Fed’s forecast revisions since December reveals its confused thinking. The central principle of anti-inflationary monetary policy is that to reduce inflation it is necessary to raise real rates. Equivalently, it is necessary to raise interest rates by more than the inflation being counteracted and above a neutral level that neither speeds nor slows growth. I had thought this was universally accepted following the work of former George W. Bush administration official John Taylor and former Obama administration Council of Economic Advisers chair Christina Romer and her husband, David Romer.
Yet because of upward revisions in the inflation forecast, the Fed’s predicted real rates have actually declined in recent months. In other words, the FOMC’s plans do not even call for keeping up with the rising inflationary gap. It is hard to see how interest rates that even three years from now will be about 2 percentage points less than current rates of inflation can reasonably be regarded as providing sufficient restraint.
Does any of this matter as long as the Fed is raising rates? Some will reject my concerns as technical quibbling. But under what reasonable economic model does rapidly declining inflation occur alongside negative real interest rates and record-low unemployment?
Perhaps the Fed still believes that inflation is in fact transitory and that it will evaporate as supply chains are restored. This has never seemed plausible, given accelerating residential and wage inflation and room for acceleration in the costs of health care, airfare and lodging. It seems even less plausible today, with war in Ukraine and covid lockdowns in Asia.
Or perhaps the FOMC members are wary of pessimistic forecasting. But why shouldn’t they forecast realistically? It is an odd and damaging view of democratic accountability that demands disingenuous forecasts from revered institutions. In a world where financial crises are always possible, the credibility of the Federal Reserve is a precious asset. It should not be lightly sacrificed.
Our democracy is more threatened at home and abroad than at any time in the past 75 years. Rampant populism is a product of inflation and distrust in government. The Fed is outside of politics but not our civic life. It has an obligation to display more intellectual rigor and honest realism than it did this week.