Honey, I Raised the Fed Rate Again

For the 16th time in a row, the Federal Reserve has raised its benchmark interest rate, bringing the federal funds rate to 5 percent.

The rate hike was widely expected. The question among soothsayers who parse the entrails of the Fed's statements was not whether this hike would occur, but whether the committee would signal an end to the long climb that began back in June of 2004 when the rate was 1 percent.

When the Fed funds rate was at a 40-year low and the economy was beginning an expansion, rate hikes were as close to no-brainers as such things get. Now, Federal Reserve Chairman Ben Bernanke and the rest of the Open Market Committee are deep into a 3-D chess game, with many crosswinds blowing in all directions.

The language in last week's announcement suggests that Bernanke and Co. will be doing some serious data mining to determine their next move.

First and foremost, they'll be evaluating conditions in the macro-economy, specifically growth and inflation. GDP grew smartly in the first quarter of the year—up 4.8 percent—but is widely expected to slow in coming quarters. There are important forces pushing back against faster growth right now, including higher energy costs, a cooling housing sector, heavily indebted households, and, of course, the Fed's own higher interest rates. One influential consensus (the Blue Chip) forecasts the economy expanding at a 3.1 percent rate for the rest of the year.

From the Fed's perspective, this says hold 'em (i.e., don't raise any further). Prior rate hikes are already taking hold, and there's a danger of hitting the brakes too hard. Last month's disappointing job gains of 138,000 was hopefully a hiccup, but if it persists, the last thing we need is higher rates pushing against labor demand.

Inflation hawks, on the other hand, are spooked by some recent sightings of wage gains (it's about time!), and fear higher labor costs will pass through to prices. But the recent Fed statement noted that “ongoing productivity gains” have helped keep wage-push inflation in check. This is an important point, because as noted in our recent analysis real wages are just now back to where they were in November 2001, the start of the current recovery. The last thing you want the Fed to do is to kill the party just when the working class gets there.

And by the way, let's not forget the three P's—the three mechanisms through which higher labor costs get absorbed: prices, productivity, and my personal favorite right now, profits. Given their historically fat profit margins, many firms could pay for wage gains out of profits and still be doing fine, thanks.

So here again, absent sharp acceleration in compensation growth or a reversal of productivity growth, the Fed can take a pause.

What about energy-price inflation? That, not wage growth, is what has driven prices up in recent months. Well, that's a tough itch for the Fed to scratch. Slowing the economy with higher interest rates to counteract higher energy prices doesn't make a whole lot of sense right now.

Finally, there's an interesting, potential new trend worth considering. For most of the last two years, long-term interest rates have been uncharacteristically unresponsive to Fed rate hikes—despite the Fed's relentless hikes, long-term rates didn't go up much at all. Now that the Fed is signaling they're at least considering leveling off, long-term rates have started rising, partly in response to improvements in other parts of the global economy (Ed Andrews has an interesting discussion of this in The New York Times.

It's too soon to tell, but it does raise the possibility that the Fed's most potent lever in terms of ratcheting domestic growth rates up and down—monetary policy—is less potent in a truly global economy. If so, it's not only blue- and white-collar workers whose clout has been diminished. Add central bankers to the list.

Jared Bernstein is a senior economist at the Economic Policy Institute and author of the new book, All Together Now: Common Sense for a Fair Economy.

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