Where are interest rates headed?

An article in the business section of The New York Times on Oct. 24 caught my attention recently. It was written by Neil Irwin and titled “A Guiding Principle That May Lead the Fed Astray.” It brought me back to Economics 101,” as taught by my professor Charlie Hyde, as inspired by famed economist Paul Samuelson. In those days, economic principles were carved in stone and we knew we could depend on the laws of supply and demand and diminishing returns. The Times article discussed how the Federal Reserve — more precisely, its Federal Open Market Committee (FOMC) — relies on the “Phillips Curve” to provide a warning signal when unemployment falls to a level that will cause unwanted levels of inflation. The Fed has a dual mandate: to provide for full employment, generally considered to be a 4.9 percent unemployment rate, and to control inflation. The Fed targets a 2 percent “core” inflation rate as a desired indicator of healthy economic stimulus.

The concept of the Phillips Curve is simple: inflation is prone to rise when the unemployment rate drops below its “natural rate,” which, for the U.S., is said to be 4.9 percent. As an example, in the late 1970’s, the combination of the “wage push” caused by low unemployment and soaring energy costs caused by the second OPEC oil embargo are generally credited with the rampant inflation during the Carter years. Federal Reserve Chair Janet Yellen has called the Phillips Curve a core component of every “realistic” macroeconomic model, so we can assume it still plays an important part in FOMC’s policy decision-making. But the Phillips Curve was formulated in 1958 by a New Zealand economist based on an examination of wages and employment in Britain in the 1860s!

So be it, but hasn’t the economy and its impact on human behavior changed significantly since the 1860s and even 1958? In the 1800s, the world population hit 1 billion; in 1960, it hit 3 billion; today, it is estimated to be 7.3 billion. Today, the United States is rapidly influenced by economic policies and political and labor conditions elsewhere, such as China, Japan, the European Community and the Middle East.

In the 1860s, immigration, with its impact on the labor force, was slow and difficult compared to today. International money flows and interest rates now change constantly throughout the day. The average U. S. life expectancy has grown from 40.5 to 79 years. Despite living longer, many people retire early when compared to the length of their lives after retirement, often leaving them relatively healthy but no longer part of the work force.

What does all of this have to do with families in Beaufort and Jasper counties, South Carolina?

Many of those families rely on interest on savings accounts to supplement salaries, pensions and social security, but the economic impact of nine years of declining interest rates has been enormous. In 2007, just prior to the collapse of Lehman Brothers, the U.S. 10-year Treasury bond was yielding 5 percent. Today, it yields 2.1 percent and in 2012 it traded as low as 1.5percent. The good news is that inflation is low.

The bad news is that supplemental interest income is also low. As we try to encourage robust economic growth without the silent tax of excessive inflation, and try to provide reasonable sources of supplemental income without encouraging reliance on shaky corporate debt or investments, our Washington monetary policymakers and lawmakers need to look closely at our macroeconomic information and models not available to Dr. Phillips in the 1950s.

For example, we need to consider the economic impact of “employment slack,” the combination of currently unemployed adults, those who would enter the workforce if they thought a decent job was available, and the “underemployed” — people with skills and training that exceed what is required by their current jobs. This measure of employment more accurately reflects real labor market conditions because it considers the aspirational aspects of human behavior.

We also need to consider the capacity utilization rate in determining future inflationary pressures. The capacity utilization rate measures the gap between what our nation’s businesses are producing and what they could be producing. A capacity utilization rate of 80 percent is typical in non-inflationary years, but today we have a 77.5 percent capacity utilization rate. That indicates the nation can handle reasonable continuing economic stimulation.

The study and practice of economics is not an exact science, if it is a science at all. Victorian-era historian Thomas Carlyle coined the phrase “the dismal science” to describe the study of economics, but economics is one of the few areas of study I am familiar with where one can be awarded either a Bachelor of Science or a Bachelor of Arts degree.

The Federal Reserve and its FOMC have the difficult responsibility of trying to manage short-term interest rates and inflation. It is important to all of us that they use economic tools that reflect current information and not just rely on old models “because that is the way it has always been done."

Elihu Spencer is a banking expert with a long business history in global finance. His life’s work has been centered on understanding credit cycles and their impact on local economies. The information contained in this article has been obtained from sources considered reliable, but the accuracy cannot be guaranteed.