Policy
A December rate increase is likely after the FOMC did not raise the short-term interest rate target at its September meeting.
The September decision by the Federal Open Market Committee (FOMC) not to raise its federal funds target rate was consistent with most market expectations that no action would be taken, leaving the key short-term interest rate near zero, where it has remained since December 2008.
Given the expectation of rising rates by the end of this year, Fed policy makers are still on track to make an initial move toward normalizing rates at one of their two remaining scheduled meetings this year, in October and December. Since December is the bigger meeting with a press conference and the release of Fed projections, it is the mostly likely date for an initial rate increase of 0.25 or 0.5 percentage point. But a step of either magnitude would still result in a low rate compared with the historical average level of 5 percent. The Fed’s move would mostly be a signal to the market that monetary policy is tightening.
After the initial increase, it will be interesting to see if the Fed pulls back in the near future as other central banks have done in the face of disappointing economic data. Even if there is no pullback, another important unknown is the pace at which the Fed may continue to raise rates. Fed officials have lowered their projections of the pace of increases in their past four reports (Chart 4).
Even with the recent capital market turmoil and the weak global economy, the Fed’s outlook for economic conditions rose in its latest release on Sept. 17. Projected gross domestic product growth was revised up, to 2.1 percent from 1.9 percent for this year, and unemployment was forecast to fall to 5 percent from the 5.3 percent rate estimated earlier. But the projected inflation rate for 2015, as measured by the personal consumption expenditure price index, was 0.4 percent, quite a bit lower than the previous projection of 0.7 percent, indicating that sluggish inflation may play an important role in the Fed’s decision.
An objection to raising interest rates now might be that such a move could be expected to constrain borrowing, which in turn may dampen consumer demand, business investment, and economic growth. But raising the key rate may also signal that rates will be pushed even higher in the future, prompting consumers and businesses to borrow sooner rather than later. U.S. stock markets, already reflecting expectations of an increase, will react quickly to any Fed action on rates. But history shows that stock market performance has little correlation with the broader economy when viewed from a longer perspective (see AIER Issue Brief: https://www.aier.org/research/new-insight-investor).
Labor force and education trends challenge policies
Two demographic trends that have been in the works for a while—retiring baby boomers and the educational attainment of younger Americans—are limiting labor force expansion and productivity. This ultimately slows down economic growth.
The labor force increased, on average, 1.5 percent annually for several decades before the Great Recession. But since the end of the recession, it has grown by less than 0.5 percent a year. Partly this reflects the recession’s after-effects. Poor job prospects led some to drop out of the labor force. But a substantial part of the slowdown stems from demographic changes.
The oldest of the baby boomers reached early retirement age (as defined by Social Security) in 2008 and full retirement age in 2012. The push of the Great Recession and the pull of Social Security benefits have contributed to lower labor force participation rates. As boomers continue to retire, U.S. labor force growth will slow even more.
It might seem that not much can be done about this trend, since it is driven by demographic change. But there is a way to boost labor force growth almost immediately. Immigration policy could be designed to quickly add to the labor force people who have desired characteristics (e.g., young, well educated, highly skilled). Several countries, including Canada, Australia, and the United Kingdom, do this through skill-based immigration programs that offer residency or citizenship. But the U.S. has no such program, and none has been seriously proposed in Congress. Most of the political discourse about immigration focuses on illegal immigrants with very little thought given to how we can mold legal immigration to the needs of the economy.
Economic growth ultimately is determined by the pace of technological progress. Less than 35 percent of young Americans (ages 25 to 29) hold a college degree, a rate below that of countries such as Canada, Japan, Korea, or the U.K. If skill-based immigration is off the table in the U.S., the only other option to increase productivity and economic growth is to raise the educational attainment level at home.
The president’s budget proposal for 2016 includes measures to make it easier for Americans to pursue college degrees. In addition to increasing Pell Grants and expanding educational tax credits, the administration proposes a new program called America’s College Promise. It provides a federal grant to states that agree to make community colleges free for students meeting certain performance criteria, such as grade point average thresholds and progress toward graduation. States have an option to participate in this program, but doing so requires them to provide additional funding to community colleges.
Whether this initiative will succeed in increasing the number of people with college degrees remains to be seen. In any event, the effect on the overall educational attainment of the labor force will be slow. It likely would take years for states to sign up for the program, should it take effect, and for young people to acquire additional degrees. But it seems that there is no political appetite for finding a faster solution through immigration policy changes.
