The Fed Is Overestimating Economic Growth

In her speech yesterday at the Federal Reserve’s annual conference in Jackson Hole, Wyoming, Fed Chair Janet Yellen stated that “the case for an increase in the federal funds rate has strengthened in recent months.” She based that view on “the continued solid performance in the labor market” and “our outlook for economic output and inflation.”

As documented by Jon Hilsenrath in yesterday’s Wall Street Journal,the Fed has consistently overestimated economic growth since 2004. The Fed’s economic model is wrong and there is no reason to believe it will suddenly produce reliable predictions. The model also does poorly in predicting inflation, though it does not show such a bias one way or another. Continuing to rely on the Fed’s flawed model to determine policy would be foolish.

Characterizing the labor market as “solid” is misleading in the extreme. Much of the decline in the unemployment rate to which Yellen directs our attention has been due to the decline in the civilian labor market participation rate. If people give up on the labor market, they are not counted as unemployed. Far from being a sign of strength, a fall in the unemployment rate for that reason is arguably a sign of weakness in labor markets. Since the unemployment rate is no longer a reliable indicator of labor market conditions, it should be dropped as a policy gauge.

For these and other reasons, I stand by my post of August 9th that the Fed will not be able to raise rates. My only hedge on that prediction is that Yellen is putting the Fed’s credibility on the line with her continued predictions of raising interest rates. Loss of face is a poor justification for raising interest rates, but the human factor cannot be dismissed in policy making.