The Fed’s decision recently not to raise the federal funds rate ratified widely held market views that officials won’t feel comfortable raising the rate until June at the earliest. But it also raises two fundamental questions: first about whether the Fed’s policy approach today is the right prescription for the economy and second whether the Fed has the best tools to steer the economy down the right path if the outlook darkens. Both of these questions should prompt many wonder: where is fiscal policy?
Even if a June rate increase is now more likely, the Fed’s decision raises some questions about how the central bank views the economic situation. At 5.5%, the unemployment rate – a variable highlighted by the Fed in policy decisions – has fallen to a level arguably consistent with full employment. What’s more, payroll growth is resilient even in the presence of downbeat international developments. While GDP growth is weak relative to previous recoveries, it is projected to be roughly in line with estimates of potential GDP growth, and core inflation is rising.
With these factors in mind, how does the Fed explain a continuation of “life support” monetary policy for an economy not requiring life support? Is the Fed’s outlook now more bearish? Has the Fed’s reaction function changed? On the former, the forecast is not changing much even with international headwinds the central bank references. While that would seem to suggest that the reaction function has shifted, it may be, as Fed Chair Janet Yellen suggested at the Economic Club of New York earlier this month, that the Fed's reaction function includes variables beyond output, employment and inflation.
The Fed has cited an interest in bolstering the labor force participation rate as well (which did rise modestly in the most recent employment report). But there is little economic evidence to suggest that continued monetary expansion is the key to reversing the significant decline in participation after the financial crisis. Addressing this important social problem requires structural considerations, particularly in fiscal policy.
Last month’s employment data did offer modest support, but this support will not likely be sustained. Recent analysis by economists at the Federal Reserve Bank of Kansas City indicates both that the inflow into the labor market has been largely more highly educated workers and that further rises in the labor force participation rate could be modest. If so, under the Fed's present stance, the unemployment rate would fall very quickly, and the Fed's approach would have the economy running very hot. In any case, fiscal reforms – particularly to promote work through a more generous Earned Income Tax Credit and lower marginal tax rates on work for lower-income individuals – would be more potent tools.
What if the economic outlook darkens? Can the Fed combat the next recession? The central bank’s forecast suggests no recession is in the offing over the next year, and that is the consensus view among economists (including me). However, even putting aside the need for professional humility in calling economic turning points, the likelihood of a recession before a substantial normalization of monetary policy is likely not small.
Any view that the Fed has ample room to bolster economic activity with additional purchases of long-term assets needs further consideration. While such actions raise asset prices, the wealth effects are modest. Again, fiscal policy – particularly longer-term tax and infrastructure reform – offers a more potent tool. Consideration of fiscal policy is much broader than short-term stimulus. Business tax reform that promotes private investment, coupled with a long-term infrastructure program, can raise expectations regarding future aggregate demand, with substantial positive effects on output and employment. Such action requires political consensus to be sure (in the United States, presidential and Congressional agreement). That achieving such consensus is difficult is no excuse – a package of reforms rewarding work and investment and advancing infrastructure should be within the political grasp.
We are asking a lot of central banks around the world at a time when governments are failing to pursue fiscal policies and structural reforms to support growth and employment. Relying more on fiscal action would both increase economic activity and decrease the likelihood that hyper-accommodative monetary policy for an extended period leads to mispriced risks and misallocated capital.
The Fed’s statement reveals thoughts about its thinking. It’s time that such scrutiny turns to the inaction of the president and the Congress.
Glenn Hubbard is dean of Columbia Business School. He served as Chairman of the Council of Economic Advisers under President George W. Bush.