Because of the Fed, the 'Goldilocks' Economy Will Have to Wait

On Wednesday, in perhaps her last congressional testimony as chair of the Federal Reserve, Janet Yellen came close to describing an economy hitting the Goldilocks point where everything is just right.

On the brighter side of the story, she noted this:

[E]conomic growth appears to have stepped up from its subdued pace early in the year. After having risen at an annual rate of just 1-1/4 percent in the first quarter, U.S. inflation-adjusted gross domestic product (GDP) is currently estimated to have increased at a 3 percent pace in both the second and third quarters despite the disruptions to economic activity in the third quarter caused by the recent hurricanes. Moreover, the economic expansion is increasingly broad-based across sectors as well as across much of the global economy.

Yet, despite nearly describing the economy we’ve been waiting for, Yellen did not quite get there. On the darker side of the story, she pointed to subdued growth in wages, weak improvements in productivity, and the pale expansion in the labor force. Those limitations seemed to put Goldilocks in a chair that was a wee bit too hard.

There is another matter (interest rate increases) which she did not mention in her prepared testimony. When will they come and how they will affect economic growth?

Just one day before Yellen’s testimony, Jerome Powell, Fed governor and President Trump’s nominee to succeed her, addressed the interest rate question when he testified in a confirmation hearing before the Senate Banking Committee. Powell endorsed the Fed’s current policies and noted that "...the case for raising interest rates at our next meeting is coming together." It’s safe to say that the Fed will raise its interest rate target by 0.25 percentage points at the upcoming December meeting.

So, what about Goldilocks? Will higher interest rates help to make things just right? Most likely not. She will just have to bear up as best she can.

Higher short-term interest rates will brighten the day for bankers, but all else equal will not cause meaningful improvements in economic growth. Here’s why.

Under current rules, Fed interest rate increases, like the one expected in December, automatically raise the guaranteed payments banks receive on the $2 trillion in reserves they now maintain with the Fed. Right now, banks receive 1.25 percent on those balances. This is a guarantee and encourages them to keep money with the Fed instead of lending it out.

If that number goes up and banks earn 1.50 percent, it only makes them more likely to park their money with the Fed. It beats what they can make on comparable safe investments and chills the incentive to increase lending, which supports economic growth.

For Goldilocks’ prosperity to arrive, the Fed and Congress will have to change the Great Recession rules that pay bankers for not lending.