Every few days we see the release of new economic data that fuels endless speculation about the timing of the Federal Reserve’s decision to raise interest rates.
Instead of offering an over-educated guess as to the date the rate increase will happen, I’d instead like to provide a bit of explanation about how economists view the decision. What is the nature of their agreement and disagreements and how does it play into the public debate over economic policy?
The economists who influence these decisions come mostly from the Fed’s stable of several hundred researchers, numerous research universities and a few think tanks. These folks publish research in peer-reviewed scientific journals, write policy papers and work to reconcile and explain different results of that research.
Unlike many academic disciplines, and especially unlike what you hear on TV news, the economists don’t belong to vastly different schools of thoughts. There aren’t “supply siders” or “Keynesians.” Those monikers work great for a short news segment or political speech, but few economists label themselves. For the record, my doctoral dissertation was called a “New Keynesian” research question.
All the relevant published research follows a pretty basic agreement of how the economy works, the elements which are critical and what the ultimate direction most policies will take. This is true for Fed interest rate hikes, as well as most economic policy choices. The sharp disagreement among economists regarding Fed policy is mostly confined to the size and timing of these policy choices.
The common view of how the economy works is that the aggregate economy has lots of smaller markets operating within it. These markets dictate such things as large capital flows between regions all the way down to the choice of how households share work and child-rearing duties. However, most of these markets suffer some degree of imperfection.
Smoothly working markets allocate scarce resources as efficiently as possible. Poorly working markets do not, leaving in their wake shortage or surplus, monopoly prices and an overall loss of well-being. Economic research that bears on the Fed’s decision tries to better understand how a rate change will impact the economy in a world where some markets work smoothly and others do not.
The disagreement over the timing and size of a rate change then devolves to a technical understanding about efficiently markets are working in different sectors. The more effectively operating markets we have, the less the Fed should intervene. The more markets do not work, the longer the period of monetary stimulus. In the end it all boils down to how quickly business and households adjust to price changes.
If the Fed waits too long, markets that otherwise respond well to price changes will develop bubbles. If the Fed moves too soon, the imperfect markets, especially labor, will not have yet recovered from a recession. The technical research on how markets respond offers critical guidance to timing a rate hike.
In the end, it is primarily calculus, not ideology, that drives these decisions.