On Wednesday, Janet Yellen and the Federal Reserve are expected to raise interest rates a bit sooner than previously anticipated, also indicating the potential for more rate hikes through the rest of the year.
If the Fed makes this March move, we should not see it as a sign that Janet Yellen and team thinks the economy needs cooling down. In fact, inflation is still below the Fed’s target, and labor force participation continues to be weak, with many prime age workers choosing not to enter the workforce.
Instead, we should see the move as the Fed taking the opportunity to get rates one step closer to normalization at a time when doing so is unlikely to negatively impact the economy. Why will higher costs of borrowing be unlikely to slow things down? There are a few key reasons due to long-term and short-term trends in the economy.
First, the long-term. Employment in the U.S. is less interest rate sensitive than it was in the past. This is primarily due to the fact that our economy has shifted away from durable goods and production to more service industry, a case made back in 2015 by Jonathan L. Willis and Guangye Cao of the Federal Reserve Bank of Kansas City.
As Willis and Cao note, from 1960 to 2007, the share of total employment in durable goods manufacturing declined from 17 percent to just 6 percent. Between January of 1990 and January of 2017 the share of US employment in durable goods manufacturing halved from 10 percent to 5 percent. Meanwhile, the services share of employment grew from 78 percent in 1990 to 86 percent in January of this year.
Since service-based employers aren’t as quickly impacted by higher interest-rates, you have a labor market that can absorb hikes more easily than in the past. But even within manufacturing, better inventory management that makes their businesses less cyclical and impacted by changing borrowing costs.
In addition to these long-term economic shifts, in the short run the Fed also views that there remains little cyclical slack that they can help correct with continued low rates. This is a contentious view among economists and the broader public when there is still a substantially lower prime-age employment rate than before the recession. But the Fed is focused on how many people say they are both not working and actively seeking work, and this number, reflected by the unemployment rate, is back to pre-recession levels.
As has been reported in large part related to the outcome of the U.S. presidential election, we know the job market has distributional issues, with some regions and sectors thriving while others struggle. But while there may be more room for people in certain areas to enter the job market, the Fed’s mandate is for aggregate numbers rather than distributional concerns. Overall aggregate numbers for the US economy are strong. In that context, they don’t think unemployment can go much lower without inflation going higher.
Even though a lot of eyes are on the financial market, the Fed’s view is trained on the labor market. Their mandate is to promote full employment and sustain American jobs. At this point, they see that the labor market has on aggregate returned to normal, and therefore interest rates should be normalized to match.