Fed: Framing the Inflation Debate

Published on September 25, 2017

Federal Reserve Chair Janet Yellen will be giving the keynote luncheon speech at the National Association of Business Economists conference in Cleveland tomorrow on “Inflation, Uncertainty, and Monetary Policy.”

We expect her to put some further context ‎to her remarks to the press after last week’s Federal Open Market Committee meeting that had underscored the tilt in the Committee ‎consensus toward a third rate hike this year in December.

*** On balance, we think the inclusion of “uncertainty” in the working headline of her speech could be telling. In what may be something of an echo of a speech by former Chairman Alan Greenspan in 2004 on “Risk and Uncertainty in Monetary Policy,” Yellen may underscore that in deciding on rates policy amid the acknowledged uncertainty over inflation, the Fed must take a Bayesian risk management approach in weighing where the greater cost is in reversing the damage if the policy decision taken proves to be the wrong one. ***

*** Against that backdrop, we think she will lean in her speech towards noting the greater cost in the potential damage to the economy if the Fed were to be too patient in gradually lifting rates towards an equilibrium level. The same inertial nature of inflation keeping it under target for so long will also be that much harder to reverse once it is rising as expected. In other words, a rate hike in December is hardly a given — there is no present course to policy — but in effect the burden of proof will be on those arguing for taking the time to be more certain over the inflation outlook. ***

A further couple of points as prologue to what will be a major policy speech, which we think will be intended to lay a marker down framing the upcoming Fed public debate over the nature of the evolving inflation dynamics:

** Chair Yellen is likely to delve into the intellectual and modeling assumptions the Fed is working with in trying to understand the current inflation dynamics. In doing so, she is likely to review the evolution of how the Fed has viewed the inflation formation process, touching on many of the themes she laid out two years ago in Jackson Hole on inflation dynamics. In updating, she will no doubt elaborate on the concerns of a strong minority of Committee members who argue that while cyclical forces are pushing inflation up, structural, global and technological factors are still pushing the underlying trend inflation down, which may call for caution in the pace of rates normalization.‎

** In that sense, a risk management approach weighing a careful cost/benefit of potential outcomes in the current policy debate is nearly an opposite to the conditions in 2015 and 2016. Then, the Fed’s caution was still very skewed to the downside with global risks hanging over a still fragile domestic recovery, and the costs of being pushed back to the effective lower bound were so high. But in the current context, the economy shows every sign of continued above trend growth and the labor market is by all accounts near or pushing through most prudent estimates of its longer run sustainable levels.

** For a conservative, collegial institution like the Fed, however much its assumptions and forecasts are tweaked and modified to better strip out the noise from the signals in the data, one constant has been that overshooting the employment mandate has never ended well in the past. That, we think, will continue to tip the risks of too much patience even with near term inflation prints still below the 2% inflation mandate towards a fairly firm majority consensus for a third rate hike this year and a continued gradual pace of rates normalization that would bring the policy rate up toward an effective neutral rate around 1.75% to 2% by this time next year.

** In particular, the Fed will be closely monitoring the various measures of inflation expectations in the coming months, as even the FOMC’s New Keynesians are operating on an expectations-augmented Phillips Curve as the conceptual framework to how they see the inflation process. The concern, shared by hawks and doves alike, is whether raising rates amid persistently low inflation and after missing the target for years looks to be driving down inflation expectations, especially in the broader surveys. As Yellen stressed in the presser, the Fed would shift its policy stance accordingly, that is, to hold rates or even push them lower depending on the circumstances. The Fed, in other words, is not locked in to the presumed pace of rates normalization.

** One other point Yellen made last week was that while the effective neutral rate is not all that far away, assuming continued above trend growth and a further tightening in the labor market, it will also be rising towards its longer run level‎s over the course of the forecasting horizon. There is considerable debate within the Fed over the timeline and end point to that higher neutral rate, which Yellen will no doubt acknowledge. But on the other hand, she is likely to indicate the assumption of a rising neutral rate as the economy continues to improve will remain the base case assumption to the outlook, as the Fed gingerly probes towards neutral in its gradual pace of rates normalization.

** Indeed, that is the primary reason for a gradual pace rather than risking the possible need to move more quickly if inflation does start rising more clearly as expected next year. Again, the risk management assessment points to continued rate hikes as the more prudent policy path. Inflation in the Fed’s updated models since prior to the crisis is much more inertial and less responsive to slack – which is why it didn’t go negative when demand collapsed and unemployment shot up to 10% – but in Yellen’s view, it also means once underway, it could also be less responsive to increases in the Fed funds rate than perhaps previously assumed.

** Adding to the calculations in such a risk management approach, Yellen may touch again on her thesis about the flipside of downward nominal wage rigidity, in that while the strong resistance to cutting wages amid a severe downturn limits inflation from falling more than it did, there could be a pent-up wage deflation that will finally give way to a broadly-based wage growth and a faster pace of rising inflation as businesses find their footing on pricing power. So while the Fed has had the luxury of patience in gradually removing accommodation, it would be risky to be too patient, for it may prove hard to bring inflation back down once it is pushing past the symmetrical 2% inflation target if the Fed should stay too far below the current estimates of the effective neutral rate.

** Again, we think Yellen will be careful to acknowledge a sense of prudent caution against moving prematurely on rates again before the Fed is feeling more confident about the inflation outlook. But to be clear, the decision will still be based on the inflation forecast, not the immediate inflation data. And in the uncertainty that always surrounds forecasts, that is where the cost/benefits calculations of the risk management approach comes into play, a factor that, assuming the economy continues on its above trend growth, we think tilts the FOMC towards a rate hike in December.

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