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'The Economy Is Often Not So Compliant'

Irwin M. Stelzer

A few weeks ago I suggested that we now know when Federal Reserve Board chair Janet Yellen will raise interest rates: never. Her first formal monetary policy speech can be read to support that view, or at least that “normal” interest rates are what the Economist describes as “a distant prospect.” It will take more than the recent spate of good news to stay Yellen from her course.

The Beige Book, a survey of the 12 Federal Reserve districts, was released on the same day as Yellen addressed the New York Economic Club. “Economic activity increased in most [ten] regions of the country ….Consumer spending increased in most Districts … the transportation sector generally strengthened… manufacturing improved… home prices rose modestly and inventory [the stock of unsold houses] remained low….loan demand strengthened … labor market conditions were mixed but generally positive.” Not too shabby as the ‘tweens like to say, in other connections, of course.

Retail sales in March recorded their best gain in a year and a half (+1.1 percent over the previous month), and estimates for January and February were revised upward. That prompted Goldman Sachs’ economists to raise their guess as to what the overall growth figures for the first quarter will show, and Bank of Tokyo-Mitsubishi chief financial economist Chris Rupkey to tell the press, “The linchpin of economic growth, the consumer, is back.” Some analysts doubt whether the pace of the last two months can be maintained, in which case the economy will continue to plod along at a 2 percent growth rate or less. But many mall operators report increased foot traffic, and Mike Jackson, CEO of AutoNation, America’s largest car retailer, says he expects vehicle sales this year to hit 16 million units, topping the 15.6 million cars and light trucks sold last year, which was “a boffo year” according to the industry press.

Other signs are just about as good. Industrial production in March rose smartly, and the manufacturing sector more than regained the sharp, weather-related losses it experienced in January. The much-watched Thompson/Reuters/University of Michigan index of consumer sentiment is at its highest level since July of last year. Those who worry about the government’s deficit found relief from the non-partisan Congressional Budget Office (CBO), which lowered its prediction of the red ink the government will spill both this year and later in the decade.

Finally, more and more companies now say they will stop buying back shares, increasing dividends, and squirrelling away every last penny, and instead increase spending on plant and equipment. Such spending, which rose by a mere 1 percent in 2013, looks set to rise by 6 percent this year, according to data provided by FactSet. The rule of thumb has been that when the economy is producing at 80 percent of capacity, businesses have to expand to meet demand. It is now operating at 78.8 percent of capacity.

If the capital spending materializes, the Fed can take a bow. Low interest rates make it cheaper for companies to borrow to fund that spending, which is what they are doing. The six largest banks report that commercial loans outstanding increased 8.3 percent in the first quarter compared with the same period last year. The increase was helped by the better financial condition of potential borrowers, making lending to them less risky, and regulatory crack-downs that have made many less traditional areas of the banking business less attractive than plain vanilla lending.

Throw in an increase by the World Trade Organization (WTO) in its forecast of the volume of world trade, and an upward revision of International Monetary Fund forecasts of global and U.S. growth, and the only problematic bit of data relates to the housing market. The seasonal selling season is off to a slow start, but whether that is because higher house prices and interest rates are stifling demand or because inventories of unsold homes are very low cannot yet be determined. If it’s high prices and rates, sales might disappoint; if it’s low inventories, expect construction activity to pick up.

All in all, the news can only be described as good. “The recovery has come a long way,” announced the Fed chair to her New York audience. So will the Fed raise interest rates any time soon? Well, no. For one thing, in the view of “many forecasters … a return to full employment … is projected to be more than two years away,” Yellen reported. For another, even if the Fed’s forecast that “maximum employment” is achieved by the end of 2016 – an unemployment rate of between 5.2 and 5.6 percent – it will be necessary to form “a more nuanced judgment about when the recovery of the labor market will be materially complete.” Maximum employment alone is not enough. Put slightly differently, Yellen wants to be sure that “significant slack” in the labor market is a thing of the past.

In addition to maximum employment, Yellen would want to see a significant drop in the number of long-term unemployed, and in the number of workers involuntarily working short hours, and a rise in the labor force participation rate, and a rise in real wages before considering raising interest rates. She would also want the inflation rate to be moving up from its current annual rate of around 1 percent to the Fed’s target of 2 percent. Absent such an increase, the economy might tip into a deflationary spiral such as saddled Japan with decades of stagnation.

Yellen believes that all of these conditions can be met if only the economy would grow more rapidly. Not for her the argument that monetary policy has reached the limits of its effectiveness. Or that structural changes in the labor market will make it difficult for unskilled and deskilled workers to find work even in a rapidly growing economy – despite the fact that many industries are reporting labor shortages at a time when the unemployment rate stands at 6.7 percent. Or that many employers won’t offer more than 29 hours of work per week lest they be required by Obamacare to pay for health insurance.

Say this for Janet Yellen. She knows the forecasts on which she necessarily relies might be very wrong. “[I]f the economy obediently followed our forecasts, the job of central bankers would be a lot easier … Alas, the economy is often not so compliant.”

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