Will the Federal Reserve allow the economy to run hot?

At this point in history, the benefits of an overheating economy outweigh the detriments of a little inflation.

some-like-it-hotThe Federal Reserve controls the economy’s gas pedal. They can step on the pedal by lowering rates to inject more fuel into the economic engine. They can also let off the gas by raising interest rates.

For the last eight years, the federal reserve held the pedal to the metal, but even at top speed, the economy wasn’t firing on all cylinders. Finally, the economy appears to be recovering from the 2008 recession. Unemployment is low, growth is stable, and wages are finally starting to rise.

With as dismal as the economy has been for the last decade, many probably wonder why the Federal Reserve raises rates at all. Why not just keep applying the gas?

If the economic engine runs too hot, the demand for goods and services exceeds the economy’s ability to supply it. Employers must compete for workers, wages go up, and workers flush with cash further increase demand for goods and services. It’s a virtuous circle — if it doesn’t go on too long because rising prices and rising wages lead to inflation.

Inflation is a stealth tax on wealth because it erodes the buying power of money (stored labor). Fiscal conservatives abhor inflation, but liberal economists adore it. Small amounts of inflation benefit workers at the expense of the wealthy, but large amounts of inflation hurts everyone, particularly those workers who don’t see pay raises to keep up with inflation.

Populist versus establishment decision

How Trump deals with inflation will speak volumes about whether he favors working-class populism or establishment conservatism.

If he promotes an economy that runs hot, it will greatly benefit the working class. They will have plenty of job opportunities, and their bargaining power in salary negotiations will be much improved. In other words, running a hot economy is a populist thing to do.

Of course, running the economy too hot is the last thing establishment Republicans want to see. Inflation erodes their wealth, and it puts management and capital at a disadvantage to workers. Most conservative Republicans want an economy strong enough for workers to buy goods and services, but not so strong that these workers can demand higher pay.

Presidents face limits on what they can do to stimulate the economy. The Federal Reserve is an independent organization specifically to prevent it from becoming a political tool. History proves that governments can’t be trusted to control the currency. But Trump has options to steer Federal Reserve policy if he chooses to do so.

The simplest thing he can do is meet with Janet Yellen and tell her he wants the economy to run hot. If she resists (which she probably won’t), he can issue an ultimatum, “If you want to keep your job in 2018 when it’s time to reappoint the Federal Reserve Chair, you will do what I ask now, or I will replace you with someone who will.” It’s not like Trump is squeamish about firing people.

When you think about it, the President has significant leverage to steer Federal reserve policy.

Goldman: Letting the Economy Run Hot Is No Panacea for Participation

Luke Kawa, October 25, 2016Janet-Yellen-in-Banker-Instinct

What are the potential gains from letting the economy run hot?

That’s the question on every economist’s mind right now after Federal Reserve Chair Janet Yellen managed, in a footnote of her recent speech, to elevate a fundamental question about the influence of aggregate demand on potential supply. …

In fact, that’s what Fed Chair Janet Yellen was referring to when she discussed the potential benefits of letting the economy run hot — chiefly, reversing hysteresis (the tendency for deep recessions to have a permanently scarring effect on a portion of the unemployed, prompting them to withdraw from the labor force for the long-term).

“We continue to see only limited room for a substantial further increase in the labor force participation rate,” concludes Mericle. “As a result, we expect the unemployment rate to resume its earlier decline before long and reach 4.5 percent by the end of 2017.”

Yellen is predisposed to run the economy hot. She’s telegraphing her intentions in her speeches. If the analysts are correct, and if we can expect fewer long-term unemployed to return to the labor force, more wage growth is on its way because employers will be forced to compete for a limited supply of labor, something they haven’t contended with for a decade.

How would a hot economy impact real estate?

Janet_Yellen_housing_bubbleHousehold income is a fundamental determinant of house prices. If more people find jobs, and if people earn more money, real estate should respond favorably both in volume and in price, which is particularly good news for homebuilding.

The caveat concerns mortgage interest rates. A hot economy generally brings higher borrowing costs. If mortgage rates rise, it will harm home prices and market momentum because rising rates price out marginal buyers. A 1% rise in mortgage rates needs a 12% rise in wages to compensate.

However, in Donald Trump’s world, rising mortgage rates constitute a minor problem. His supporters live in flyover country where houses are very affordable. Rising mortgage rates harm affordability everywhere, but the impact will be muted where Trump’s supporters live. The costly coasts, the areas that didn’t vote for Trump, would be impacted much more strongly by higher rates. Most of California or New York would become unaffordable, but Trump has little reason to care what happens in those areas.

Why the economy will be allowed to run hot

Realistically, we need inflation. Most people carry too much debt. Millennials strain under the weight of excessive student loan debt. Generation X struggles under the weight of their bubble-era mortgages. And even the Boomers carry far too much consumer debt into their retirement. This debt will never be repaid in today’s dollars, so inflation benefits far more people than it harms right now.

The bond market senses this. The sharp selloff since Trump won the election demonstrates that market participants believe inflation is finally on the horizon.

I was in grade school during the Stagflation of the 1970s. I don’t relish the thought of another period like that one, but after living through the opposite extreme for the last decade, I’ll live with a little inflation for a while. It beats the alternative.