Fed’s Lockhart: Interest Rate Increases Coming, Even If Unemployment Does Not Drop ‘Considerably’

In a speech this morning at Atlanta Technical College, Dennis Lockhart, the president of the Federal Reserve Bank of Atlanta, said that the Federal Reserve will raise interest rates even if unemployment has not fallen “considerably.” It is the strongest indication that the Fed will move to raise interest rates when prices show signs of inflation, even if the unemployment rate — still flirting with double digits — remains a serious problem.

He first describes the current economic paradigm: a recovery, but a slow one characterized by unemployment in or near the double digits:

Most indicators suggest that overall economic activity stopped contracting and began growing again starting around July 2009. So the economy is approaching 12 months of sustained recovery, and yet not much has happened in employment markets to reduce the high level of joblessness. How can that be? During the last three quarters, gross domestic product (GDP) has expanded at an average annualized rate of 3.6 percent. Current estimates point to GDP growth of around 3 percent in the current quarter. These numbers are not off-the-charts strong, but they represent solid aggregate economic performance.

He then further characterizes the recovery:

In the middle of last year government spending stimulated most of the economic growth. In the fourth quarter of 2009 and the first quarter of this year, inventory adjustments drove a lot of economic activity. Consumer activity over the last few months has exceeded the expectations of many analysts. This activity has occurred even while American households continue to deleverage, that is, pay down their debt. Business investment in equipment and software has been surprisingly strong considering the consensus forecast of modest growth ahead. Both consumer spending and business investment in capital goods may just be evidence of short-term and temporary satisfaction of pent-up demand following deferral of spending during the recession. The end game of this evolution is solid and broad-based final demand.

But he cautions that the recovery might remain jobless, or at least not “job rich,” though he believes that productivity gains might have maxed out and at some point companies will start hiring again:

We will get another important reading on employment markets tomorrow. Even if that report shows further gains in employment (some forecasters expect 500,000, with 400,000 being U.S. Census jobs), it’s fair to say there will remain a large excess of workers looking for jobs relative to the demand for workers in the economy. Total jobs lost in the recession and immediate aftermath approach 8 million. This gap is likely to close only gradually. And, further, the resulting slow growth of wages and salaries has the potential to limit growth of consumer spending for a while.

Then, the other shoe drops:

The Fed has held its interest rate policy at close to zero for about a year and a half. This has been done to foster conditions that would end the contraction of the economy and then encourage recovery. Again, I believe a modest recovery has been under way for almost 12 months. As I stated earlier, the Fed has a dual mandate from Congress to keep inflation low and promote maximum employment. I’ve put forward the view that inflation is not currently a major concern. So one might ask, do you believe the base interest rate must remain near zero — at its current level — until unemployment is reduced substantially and most of the employment lost in the recession has been restored?

I’m not convinced that will be necessary. I continue to support the current stance of interest rate policy. But the time is approaching when it will be appropriate to consider recalibrating interest rate policy. I do not believe that time has yet arrived. The conditions that require a change of policy are not yet at hand. However, as the economy continues to improve and financial markets find firmer ground, extraordinarily low policy rates will not be needed to promote recovery and will become inconsistent with maintaining price stability.

The implication is that the policy rate may have to begin to rise even while unemployment is considerably higher than before the recession. I’m very concerned about unemployment, and certainly employment trends should be a critical consideration in setting policy. But I accept that good policy, even in circumstances of unacceptable levels of unemployment, may incorporate higher interest rates.

Now, Lockhart is not advocating hiking the interest rate immediately or warning that even if the unemployment rate sticks around 10 percent the Fed will tackle inflation when it comes. But this is the first time I have seen a Fed governor admit that the Fed will raise interest rates even while unemployment remains “considerably higher” than it was before the recession. (In 2006 and 2007, the unemployment rate hovered around 4.6 percent.)

One major argument Lockhart makes for raising interest rates despite high unemployment is that he believes some of the current job loss to be “structural” rather than “cyclical.” The construction industry, for instance, will not replace all of its jobs when the economy turns around, since so many of those jobs were created by the credit and housing bubbles. Even if the Fed kept interest rates near scratch, it would not help to bring those positions back.

The question remains the threshold at which the Fed would consider unemployment low enough to consider raising interest rates. At 7.5 percent? Or at four job seekers per job? Nobody knows for certain. Regardless, unemployment looks to be high for a long time. And a broad swath of dovish economists will urge the Fed to privilege reducing unemployment over tackling inflation whenever it is that the Fed moves to raise the interest rate. (The Fed continues to say that rates will remain low for an “extended period.” When it drops that language, it will be an early sign that it is considering rate hikes.)