Watch CBSN Live

How the Fed might react to the jump in GDP

Latest MoneyWatch headlines

Before the release of the latest GDP report on Friday, most analysts believed that the Federal Reserve’s monetary policy committee would keep interest rates on hold when it meets later this week. Will news that GDP growth rose to 2.9 percent in the third quarter of this year -- better than the forecast of 2.6 percent --  change that assessment?

Beyond noting that this initial estimate will be revised as more complete data arrives, it’s important to recognize that part of the GDP increase is due to the accumulation of inventories (goods that are produced and then held as inventories are counted as part of GDP). Accounting for inventories, the growth in final demand was 2.3 percent. That isn’t bad, but it’s not sufficient to generate worries that rising demand will produce significant inflationary pressure.

What the Fed will be more worried about is “cost push” inflation -- rising prices due to an acceleration in the cost of labor and other inputs to production. 

How close are we to an interest-rate hike?

Here’s why. When the economy is in recession and unemployment is high and resources are idle, firms can expand production without much change in their costs. Unemployed workers can be rehired at the going rate, and input suppliers are eager to rid themselves of inventories that have piled up as firms cut back during the recession.

However, once the economy reaches full employment the situation changes. There’s no longer a reserve of unemployed workers to draw on, and hiring, say, a new engineer likely will require the firm to offer a wage sufficiently high to induce the engineer to switch jobs.

Similarly, if input suppliers are working at capacity, as they are when the economy is operating at full employment, expanding production will require the firm to make higher bids for resources. For example, it it wants to use more steel, it must be willing to pay a higher price than the firms that are currently buying it from the supplier.

If demand keeps growing once the economy reaches full employment, as it would if the Fed leaves interest rates too low for too long, rising input costs can cause inflation to increase rapidly. That’s why the Fed pays so much attention to the labor market.

And here the picture is less than clear. Although the unemployment rate has been relatively low, at 4.9 or 5 percent since October of last year, and the economy has been expanding, there has been very little upward pressure on wages and the price of inputs. 

Wage growth has been a bit better recently, but the increase has not been sufficient to produce worrisome inflationary pressure. In fact, the core price index the Fed watches closely has been falling since the beginning of the year (prices were rising at a 2.1 percent annual rate in the first quarter of 2016, 1.8 percent in the second quarter, and 1.7 percent in the third).

American men are struggling with employment

How is it that the economy can expand for a year with unemployment so low without producing significant upward pressure and wages? As conditions have improved, many workers who left the labor force during the recession (and therefore weren’t counted in the official payroll statistics) have returned. Thus, we have not yet reached the point where workers are so scarce that it would cause wages to rise rapidly as firms attempt to expand production. 

Last month, for example, approximately 7 million people aged 25 to 54 weren’t in the labor force, and it’s difficult to estimate how many will choose to return to work as the economy continues to improve.

This puts the Fed in a tough situation. Due to the lag between the time interest rates are changed and the impact of the change on the economy, to avoid inflation the Fed must begin raising interests rates before the economy reaches the point where labor is in short supply. But if it makes a mistake and raises interest rates too soon, it could leave workers who would have been willing to work unemployed.

Which mistake is worse, raising interest rates too late and risking inflation, or raising them too soon and risking lower-than-optimal levels of employment? 

An outbreak of inflation can be contained relatively quickly through aggressive increases in the Fed’s target interest rate, but employment that’s too low is much harder to reverse, and it can have long-term consequences. Workers who have left the labor force and might have returned can be lost permanently. If that happens, productive workers who could have raised national output and pay taxes will be missing, and in many cases they’ll need to be taken care of by their families or the government.

For this reason, I believe the Fed will want to wait for clearer evidence that the flow of people back into the labor force can no longer offset inflationary forces before it raises interest rates again.

That could come at its December meeting, and it’s likely that the Fed will begin setting the stage for a rate increase at that time while doing its best to make it clear that its policy decision will be “data-dependent.”

View CBS News In