Op-Ed: The Fed is doing good work — the economic policy problems are elsewhere

The American monetary authority is holding the economy and the financial system in a reasonably good shape in an environment of price stability. That is a laudable achievement under conditions of rising uncertainty about public finances, structural economic and social reforms and foreign trade issues.

Many people militantly disagree with this view, even though the financial markets are taking U.S. equity valuations to record-high levels in response to properly calibrated monetary policies.
The question to naysayers is this: What else are the markets responding to?

Carlos Barria | Reuters

Federal Reserve Chair Janet Yellen testifies before a Senate Banking Committee hearing on the 'Semiannual Monetary Policy Report to the Congress' on Capitol Hill in Washington, July 13, 2017.

Would they like to try these for better answers: (a) stalled health-care legislation, (b) difficulties with passing the proposed tax code changes, (c) no evidence of sorely needed infrastructure investments, (d) tinkering around the edges of foreign trade problems or (e) absence of any progress in swaying China and a German-led Europe to change their trade policies that cost America $512 billion in trade deficits last year and $204.5 billion in the first five months of this year?

And all of that is happening at a time when the Republican Party comfortably controls America's legislative and executive authorities.

Meanwhile, that's all in full view of America's strategic competitors, who understand that they are dealing with a country whose economy is held back by a pathetic 1.6 percent growth potential as a result of inadequate labor and physical capital resources.

Monetary policy and 'nothing-burgers'

This broader context is necessary to understand the Fed's role in the management of the U.S. economy. Crucially, that uninspiring broader context also explains the Fed's hesitation to initiate a more systematic process of "policy normalization" — a short-hand for liquidity withdrawals and a move out of negative real short-term interest rates.

In fact, some of the most recent Fed statements are clearly implying that they don't think much of the announced economic stimulus measures: tax cuts, infrastructure investments, market deregulations and better foreign trade policies. The Fed maintains modest growth expectations — somewhere around 2 percent — and an apparent intent to move toward a neutral policy and a slow and gradual credit tightening over the next few years.

Here is what some of that means: Assuming that inflation (measured by the CPI) remains at about 2 percent over the relevant policy horizon, the effective federal funds rate would have to be raised by 84 basis points (from its current level of 1.16 percent) to match that inflation rate and reach a roughly defined point of monetary neutrality. To get there, there would have to be at least three more interest rate increases of 25 basis points.

Obviously, this scenario would be radically different if the Fed felt more confident about the implementation of meaningful economic stimulus measures. Anticipating those events, the Fed would accelerate its schedule of interest rate increases to anchor inflation expectations and limit bond market problems. The fact that it is not doing that simply means the Fed has serious doubts about the fiscal agenda and the rest of the proposed growth-enhancing actions.
So, the Fed sounds like it wants to change the subject and stay away from a policy argument. It is puzzling instead over the wage and price inflation while telling the White House "good luck with your 3 percent GDP growth target."

Raise the supply and quality of labor

But that's hardly changing the substance of the dialogue about economic policies because rising wages and prices can only happen as a result of increasing demand pressures in labor and product markets.

One of the Fed governors aptly observed last week that wage inflation will begin to accelerate when we see a real tightening in labor markets. In other words, he is telling people not to fret about a 4.4 percent unemployment rate, and he is absolutely right.

Indeed, America's executive and legislative authorities have some work to do to improve the labor markets. The actual unemployment rate is double the officially reported rate of 4.4 percent once you add people without a stable employment (involuntary part-time workers) and people who gave up looking for a job or dropped out of the labor force (people marginally attached to the labor force). Some 6.9 million people fall into those two labor market categories in addition to the 7 million people without a job recorded in the usual monthly surveys.

And then 37 percent of the active civilian labor force remains out of the actual labor supply, with 1.7 million of the officially reported job seekers who are becoming virtually unemployable.

That huge pool of labor supply — rather than the idea of low-paying jobs — largely explains why nominal compensations in the year to the first quarter rose only 2.3 percent, even though the reported unemployment rate declined over that period to 4.5 percent from 5 percent.

That also explains rising profits and soaring equity prices because wage growth minus productivity gains kept unit labor cost increases down to 1.1 percent, showing that capital is taking most of the expanding output shares.

The message for the White House and the Congress is simple: Get back to work some of the 102 million people who are either out of the labor force or without stable employment, and make it possible for them to get a proper training to be more productive and to fit new job opportunities. That would boost America's potential growth rate back to an average of 3.2 percent (from 1.6 percent now) observed during the 1990s.

Raising the country's growth potential would also trigger increasing business capital outlays. Lowering the corporate tax rate is only part of the story. Cutting down the cost of capital may just accelerate the implementation of existing investment projects, but it won't raise the level of the desired capital stock. Businesses will only expand factory floors and buy new machinery and equipment if they cannot satisfy actual and expected sales from production capacities they already have.

Active labor market policies have also to be accompanied by greater investments in education and health care to increase the stock and the efficiency of human capital.

In the absence of that complex set of policies, the White House pledge of a 3 percent growth rate will remain out of reach with the current noninflationary growth potential of 1.6 percent — the sum of the annual labor force growth of 1.4 percent and dismal productivity gains of 0.2 percent.

Investment thoughts

The Fed is maintaining its exceptionally easy policy stance because it is not expecting substantial economic stimulus measures in the months ahead. The key items of the administration's economic and social agenda — tax code changes and a health-care plan — are moving slowly (if at all) through the legislative channels, even though the Republican Party has a majority in both chambers of Congress.

There are also no signs of advancing infrastructure investments programs.

Meanwhile, foreign trade remains a significant drag on economic growth. In the first five months of this year, the trade deficit is running 9 percent above its year-earlier level. A further deterioration is expected since there is no agreement with Europe and China on a more balanced trade relationship.

Equity markets are responding to monetary policies that are supporting moderate economic growth, where subdued unit labor costs are translating into rising corporate profits.

But the outlook for longer-term growth and financial market stability is quite uncertain. The administration's economic stimulus and reform programs are experiencing difficulties in an unexpectedly complicated legislative process.

Commentary by Michael Ivanovitch.

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