What will happen to interest rates?

With the first indication that the economic recovery that started in 2009 might begin to advantage the average American worker, you could be sure the interest rate hawks were all over the Federal Reserve at its latest quarterly meeting this week to start raising interest rates in anticipation of future inflation. It wasn’t going to happen and the reasons go beyond what Chair Janet Yellen told the press.

Even though commercial banks own shares in the Federal Reserve Banks and the Federal Reserve System acts on behalf of the Department of the Treasury in managing the money supply and setting interest rates for the banks and the Treasury, it is controlled by its Board of Governors; the Board is a federal agency and its seven members are appointed by the president. In that sense, it is a quasi-public agency whose mandate has been to maintain full employment, stable prices and control inflation.

While there is uniform agreement among economists that a modest amount of inflation is important for the growth of an economy, the worldlier members of the Federal Reserve Board are aware of a number of factors that strongly suggest that low interest rates had to be the policy of choice.

Factor No. 1: It its last report, the Fed indicated that inflation-adjusted income for 90 percent of working Americans fell 5 percent for the years 2010 through 2013, while economic growth for the country was cumulatively up 9 percent. The report that November wages increased by 0.4 percent (4.8 percent if you annualize it) represents the first time since the recovery began that average workers were seeing the impact of the nation’s “modest growth” rate provide them with a leg up on the current rate of inflation (1.7 percent). One month does not a trend make. To boot, wages for lower-paid workers in “nonsupervisory and production roles increased only 0.2 [2.4 percent annualized] percent.”

{mosads}If November does represent a reversal, there is so much ground to make up that it is unlikely at the extreme that a person such as the Fed chair would be inclined to jump on board with those who believe that the Fed has to be way out in front on the inflation issue. These hawks will argue that interest rates have remained near zero for the past six years and maintain that the likelihood is that there will be a rapid rise in inflation as soon as the hoi polloi start feasting on financial benefits.

There are a few holes in this argument, in addition to the short-term impact of the good news on wages. First, full employment is part of the Fed mandate, even though it has largely been ignored as a goal since Republicans took over in 1980. It is beginning to be more important. Fed Board members can’t be indifferent to the fact that the latest unemployment figure of 5.8 percent doesn’t represent full employment (even though there are arguments as to how low that number has to be; estimates range from 4 percent to 6 percent). Most of us know that the official rate severely undercounts actual unemployment, not including underemployment, those who are discouraged and left the work force, etc. (estimated to be as much as twice the reported number). Yellen rightly made that point in her press conference.

Factor No. 2: The rapid decline in oil prices worldwide has been a boon for the Fed. The boon is that the average of $1,200 estimated to be saved by American drivers and homeowners on annual fuel costs is the same as a tax cut or other form of stimulus to the economy, which means simply that the growth rate for the next year or more is locked in while taking the pressure off any thoughts of inflation being a short-term issue. Yellen was quite clear on that point.

Since the Fed has been the only force since the American Recovery and Reinvestment Act  stimulus package of 2009 available to support the recovery, declining fuel prices are a substitute for the fiscal stimulus suggested several times by previous Fed Chair Ben Bernanke. The Fed typically looks at “headline inflation” (food and fuel prices) as volatile, cyclical and more than likely to reverse in fairly short order. What is not clear to the governors is that this time, lower fuel prices may be a prolonged because of the amount of energy oversupply and the extent of slow or negative growth outside the U.S. and around the world.

Factor No. 3: While lower oil prices are a boon to the U.S., declining oil prices are a crippling blow to underdeveloped countries and oil-producing countries. Oil is paid for in dollars and declining revenues place pressure on currencies. If the Fed were to raise interest rates, it would further exacerbate the suffering since it is estimated that every 1 percent increase in long-term Treasury rates redirects $125 billion in investment capital from poor countries to the U.S. If, as is the case with the U.S., 12 percent of your total production of goods and services is represented by exports, it is not good policy to inflict this type of pain on your customers.

Factor No. 4: The specter of deflation is a far greater concern to the Fed than Yellen let on. This is something the Fed has been fretting about for the past three years. Oil is such a commanding presence as a commodity that it effects virtually all others. Combine its price decline with diminished herds of cattle due to drought conditions and numbers of pigs because of disease, with record production in corn and soybeans, and you have a cocktail made for broad-scale price declines.

Factor No. 5: The housing market in the U.S. has not demonstrated a strong recovery since it crashed in 2008. The Fed chair made no mention of it. To quote Bloomberg News, “The residential real estate recovery in the U.S. is best described as plodding, with the industry taking a step back in November for the first time in three months.” According to the National Association of Home Builders, “historically, residential investment has averaged roughly 5 [percent] of GDP [gross domestic product] while housing services have averaged between 12 [percent] and 13 [percent], for a combined 17 [percent] to 18 [percent] of GDP.” If that sector is “plodding” and you are a Fed governor, are you going to vote to raise mortgage rates? Not likely.

Factor No. 6: Federal deficits are declining from the $1.4 trillion recorded in 2009 to $564 billion estimated for fiscal year 2015. Analysts and Fed governors who worry about deficits are greatly alarmed when the total federal debt exceeds the annual total of goods and services produced in a country. For example: Japan’s national debt is over 200 percent of its annual GDP. In the U.S., total public debt is $17.6 trillion, which is 103 percent of estimated GDP for 2014. But here is the catch: Public debt represents money spent and owed. If the money used to repay the debt is subject to inflation, it is worth less, which is one of the reasons why some inflation is good. If the economy grows by 2.5 percent next year and the federal deficit comes in as expected, the total public debt will be very close to falling under 100 percent. If you take into account inflation, it is below 100 percent. Deflation makes the calculus go the other way. Raise interest rates and you slow growth and dampen inflation. Not smart policy.

All things considered, average wage earners may have caught a break. It isn’t always that the fundamentals of economics conspire to give them a lift, but this could be one of those times. The irony for the policy geeks is that U.S. economic policy should be targeting the improvement in wages over gains for its shareholders. Consumer prosperity is a tide that floats all boats.

Russell is managing director of Cove Hill Advisory Services.