KRUGMAN TO THE FED: Don't do it

Nobel Laureate Paul Krugman doesn’t think the Federal Reserve should raise interest rates in December.

Writing on his blog at The New York Times on Friday, Krugman said that while it looks like the Fed will probably raise rates in December following Friday’s blowout jobs report — particularly with the market now pricing in a 70% chance the Fed goes in December — this doesn’t mean they should do it.

Krugman’s main argument centres on inflation and wage growth.

In October, wages grew 2.5% over the prior year, the fastest pace since 2009 and a figure that appears to show a labour market finally resulting in pay increases for workers, long considered the missing piece of a labour market that had made tremendous gains in the last several years.

But as Krugman notes, inflation — on a core basis, which excludes the more volatile cost of food and gas and is the Fed’s preferred measure — is still running well below the Fed’s 2% target.

Here’s Krugman:

First of all, some perspective: while wage growth has picked up, it’s still well below pre crisis levels; core inflation is also still below the Fed’s target. And here’s the thing: there’s very good reason to believe that the pre-crisis target was too low … So the Fed should not be eager to raise rates until inflation and wage growth are at least at, and preferably above, where they were before the bottom fell out. And it certainly shouldn’t be conveying the impression that 2 per cent is not a target but a ceiling, which is exactly what it would do with a rate hike.

In a press conference following the Fed’s September rate decision, Fed chair Janet Yellen said the Fed’s credibility rests on its inflation target. Yellen added that the 2% target was “not a ceiling,” meaning the Fed wouldn’t necessarily be swift to raise rates and tamp down price increases were inflation to run above that level for some time.

Krugman, however, thinks the Fed would be sending this message were it to raise rates in December.

Fredgraph (1)FREDThat red line is the Fed;s inflation target.

The argument in favour of the Fed raising rates in December, though, is more tied to the strength of the labour market and the fact that a 0% interest rate is an emergency setting. In December 2008, at the height of the financial crisis, the Fed cut rates to 0% — well, a range of 0%-0.25% — and have had them pegged there ever since.

But with the unemployment rate at 5% (the low end of the Fed’s 5%-5.2% “full employment” range), many think it’s time for the Fed to rip the band-aid, so to speak. In a way, this logic would say that by keeping rates near 0%, the Fed is expressing concern about the strength of the US economy.

Krugman, in addition to thinking the Fed needs to wait for inflation to really pick up to raise rates, also reiterates something that has long been cited as an argument against Fed action: “the asymmetry of risks.”

This framework for thinking about Fed action basically means that if the Fed makes a mistake raising rates, it could tip the whole world economy — which Krugman says “as a whole is struggling” — into trouble. By not acting, the Fed maintains the status quo, which at least seeing the world economy stay afloat, for all its flaws.

A policy error of moving too fast could see it all break down. And in this scenario, Krugman doesn’t think the Fed has “adequate ammunition” to do anything about a downturn: rates are already at 0% and practically, it’s unlikely the Fed will be launching another quantitative easing program anytime soon.

As for the market, it is clear: go for it.

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