Domestic Consequences of FOMC Tightening
On May 22, 2013, Chairman Ben Bernanke indicated during the course of Congressional testimony that the Federal Open Market Committee (FOMC) intended to reduce the flow of asset purchases in the next few meetings. This communication marked the beginning of a gradual monetary policy tightening cycle. The Committee continued this process by raising the target range for the fed funds rate in December 2015.
The tightening of monetary policy has had two adverse persistent effects on the US economy.
The first persistent effect is on the credibility of the Committee’s 2% inflation target. The FOMC has continued to tighten monetary policy, even though inflation remains well below 2% and is not expected to return to 2% for years to come. These actions suggest that the FOMC is quite comfortable with inflation being markedly below 2%. As a result, both survey-based and financial market-based measures of longer-term inflation expectations have fallen to near-historical lows. This decline in longer-term inflation expectations is equivalent to a cut in the FOMC’s inflation target and means that the Committee will have less recession-fighting policy space.
The second persistent effect is on US labor market potential. Tighter monetary policy has helped suppress the fraction of Americans with a job. This force affects all Americans, regardless of age. But the resulting shortfall is especially disturbing for relatively new entrants into the job market. For example, the fraction of men aged 25 to 34 with a job is 4.5 percentage points lower than it was nine years ago. The tightening of monetary policy helps keep these million young men from finding employment - and so helps prevent them from building valuable labor market skills, helps block them from engaging effectively with society, and helps lower their overall lifetime potential.
I’ve described these effects on credibility and labor market potential as persistent. But that’s a pessimistic perspective. The FOMC can start to rebuild its credibility and start to rebuild America’s labor market potential. It only needs to reverse the course of monetary policy toward easing, as opposed to tightening. Changing direction in this fashion would be likely lead to external criticism and could spark internal divisions. But it would also be likely lead to a kinder eventual judgment from history.
Rochester, NY, January 10, 2016