Yellen Cites Benefits to Running Economy Hot for Some Time

Yellen Cites Benefits to Running Economy Hot for Some Time

Fed leader also warns that holding an accommodative stance for too long could have costs

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Federal Reserve Chairwoman Janet Yellen during a speech at a Boston Fed conference answers the question "What determines inflation?" Photo: AP

By

Jon Hilsenrath and

David Harrison

Updated Oct. 14, 2016 5:25 p.m. ET

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Federal Reserve Chairwoman Janet Yellen offered an argument for running the U.S. economy hot for a period to ensure moribund growth doesn’t become an entrenched feature of the business landscape.

That would mean letting unemployment fall lower and spurring faster growth to boost consumer spending and business investment.

This could encourage businesses to spend more on new equipment that would have lasting benefits for the economy and encourage future growth, she said. A fast-growing economy and low unemployment also could encourage individuals who have stopped looking for work to start looking again, expanding the labor force and national income.

Moreover, running the economy hot could encourage higher levels of research and development and increase incentives for new business formation.

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Federal Reserve Chairwoman Janet Yellen offered an argument for running the U.S. economy hot for a period to ensure moribund growth doesn’t become an entrenched feature of the business landscape, during a speech at a Boston Fed conference. Photo: AP

Ms. Yellen didn’t directly address looming policy decisions, such as whether the Fed should raise short-term interest rates before year’s end. She also avoided a short-term diagnosis of the economy’s performance, something of great interest in financial markets.

Still, her speech at a conference held by the Federal Reserve Bank of Boston offered a window into her mind-set and how policy might evolve in the months ahead. She effectively expressed sympathy for the idea of keeping short-term interest rates low to let the economy gather steam and reverse some of the long-run debilitating effects of the slow recovery, such as low labor-force participation and business investment. That implied very gradual rate increases in the months ahead.

Economic theory holds that weak demand can become a self-perpetuating problem for an economy. When businesses don’t invest and consumers don’t spend, it drives down the productive capacity of the economy and the pool of available labor, begetting still-slower growth. The idea is called hysteresis in economic circles. Weak demand begets weak supply, something Ms. Yellen said—with some careful hedges—might be reversed if demand is boosted.

“If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market,” Ms. Yellen. “One can certainly identify plausible ways in which this might occur.”

A hot economy would boost sales, which in turn would prompt managers to invest more in their businesses, she said. “In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines.”

One sign that the economy is beginning to run hot is that the U.S. jobless rate has fallen to 5%, signaling diminished slack in the labor market. Despite its descent in recent years, Fed officials have been prepared to keep interest rates low and encourage the jobless rate to fall further still.

The Fed leader didn’t come right out and endorse running the economy too hot. As a qualifier she said that “we of course need to bear in mind that an accommodative monetary stance, if maintained too long, could have costs that exceed the benefits by increasing the risk of financial instability or undermining price stability.”

In all, market analysts are likely to interpret her comments as “dovish,” meaning supportive of low rate policies.

The Fed has held its benchmark short-term interest rate in a range between 0.25% and 0.5% since December, after keeping it near zero for seven years. Most central bank officials at their September meeting expected to nudge it another quarter percentage point this year and proceed slowly toward further interest-rate increases after that.

“She seems to want to keep policy very accommodative for as long as she can while inflation is low,” said Charles Lieberman, chief investment officer at Advisors Capital Management in Ridgewood, N.J. “It is consistent with her previous public statements.”

Her comments serve in part as an antidote to a downbeat Boston Fed conference where many analysts argued that the U.S. economy is stuck in a period of slow growth, thanks to weak productivity gains and an aging workforce.

Ms. Yellen noted that the link between a tighter labor market and inflation seems to have weakened in recent years. Economists have found in the past that a falling unemployment rate tended to raise inflation, a connection known as the Phillips curve. But that hasn’t happened since the recession.

“The influence of labor-market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis,” she said.

If true, that would suggest the Fed has more room to let the labor market tighten without pushing up inflation.

Write to Jon Hilsenrath at and David Harrison at