Fed: Twists and Turns

Published on April 22, 2014

Our favorite bit in Federal Reserve Chair Janet Yellen’s Economic Club of New York speech last week was the description of the Fed’s forward policy guidance as an “automatic stabilizer.” It was an interesting way to describe what is essentially using words to keep the markets from over-reacting to every “twist and turn” in the economy’ path towards “plausible” full employment and mandate-consistent inflation two years from now.

Even more interesting will be if it works, and the Fed will soon have an opportunity find out.

*** The Federal Open Market Committee is likely to look past what are likely to be stronger second quarter numbers, just as it did with the first quarter’s soft wintry weather data, to growth settling into a pace reaching to or near 3% this year. This 3% economy will be “good enough,” relative to a marked down trend potential, to slowly but steadily bring the unemployment rate down, with a much desired growth in wages capped by the part-time, discouraged, and long-term unemployed slowly being drawn back into the full-time work force. ***

*** And for all the sudden press over a potential imminent take-off in inflation, low inflation rather than rising inflation is still clearly at the forefront of near term policy concerns. But the “good enough” economy and better though restrained wage growth should ensure against a further fall in inflation, especially if inflation expectations remain anchored. A bit like sticky wages, inflation is instead more likely expected to trend mostly sideways in a gradual upward slope. Measures of wage growth will rank high among the most important data series for the Fed over the next few months. ***

*** The FOMC meeting next week is unlikely to see major changes to the forward policy guidance, and we in fact expect the September meeting to be the most likely next major inflection point in the Fed’s policy path and communications guidance. Committee members will want to see the summer’s data before making a call on the growth and inflation trends, and as QE draws to a close, they will need to revisit the June 2011 “Exit Principles,” not to mention navigate the tricky messaging of the 2017 “dot plot.” Until then, the March statement, with its cornerstone of a “below normal” neutral interest rate, is likely to serve as the template to carry the FOMC consensus and messaging with speeches to fine tune along the way. ***

Lower Potential Growth

There is both an optimism and pessimism to the Fed’s expectations. The latter comes in the little noticed marking down in estimated trend growth potential in the Summary of Economic Projections over the last two years. In parallel to the “below normal” equilibrium interest rate that made its way into the March statement, longer run growth has been steadily dropping, to 2.2%-2.3% last month from 2.5%-2.8% % in April 2011.

Normally, of course, in a more V-shaped recovery that would also mean less running room before the monetary brakes would need to be applied to stem inflationary pressures.

But the optimism comes in two ways. First, set against a 1% inflation rate and a trend potential of no more than 2.3%, what is so bad about a near 3% growth? It is “good enough,” all else being equal, to slowly but steadily drive the unemployment rate down.

The second is the growing belief among Fed doves and centrists alike that the lower and slower pace of recovery is translating into very low odds for an unexpectedly strong pick-up in inflation, much less anything resembling an accelerationist wage-price spiral of 1970s-style inflation. “At present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2 percent,” is how Chair Yellen put it last week.

Those low odds may be based, at least in part, on the arguments articulated in a 2004 paper Yellen wrote with co-author and husband George Akerlof. They argued that after periods of a prolonged high unemployment and very low inflation, inflation will tend to move sideways rather than drop into outright deflation as most models would assume. That is in part due to Fed credibility and anchored inflation expectations, as well as changing consumer and worker behavior after the shock of high unemployment, fears over losing jobs and lost savings.

That inertia in inflation, in turn, not only checks inflation from going negative but it equally allows for what can be an extended period of a highly accommodative policy than would otherwise be the case if unemployment were closer to trend or prices were already under upward pressures.

The prize, if the accommodative policy can be maintained for long enough, is that the sustained gains in aggregate demand will in time create their own supply, further keeping a lid on inflationary pressures. In other words, accommodative policy — a little more help from fiscal policy would be nice — will go a long way to repairing the eroded capacity and labor skills lost in the Great Recession and the long subpar recovery.

This was the most prominent of the scenarios presented in the Wilcox, Wascher, and Reifschneider paper last November (“Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy”) that drew so much from an optimal control framework that Yellen had illustrated in three 2012 speeches.

The “Inflation Expectations Paradigm”

That assumed trade-off, however, between faster employment gainsand potentially higher temporary inflation never actually materialized. Inflation instead fell to around 1% rather than rise back towards 2% target as the unemployment rate steadily declined to 6.7% by the turn of this year.

This perplexing no-show of inflation has left its mark on the Fed’s current assumptions in two ways. First, as much as the faster than expected fall in the headline unemployment rate drew the FOMC’s attention on the need to update its forward policy guidance earlier this year, it was the failure of inflation to rise as unemployment fell that as much as anything else neutered the Numerical Thresholds by the time of the FOMC’s March 4 conference call meeting.

After all, if the FOMC and the staff were unsure why exactly neither inflation nor unemployment were behaving as they were, how could they be sure of the trade-off between the two that stood at the heart of the Numerical Thresholds construction?

And second, there is a thread of concern running through the Fed’s current probabilities that they may be relying too much on the “inflation expectations paradigm,” that the anchored 2% inflation expectations will keep inflation from falling further or ever descending into outright deflation. Bank of Japan officials were in fact reminding anyone willing to listen on the sidelines of last month’s International Monetary Fund meetings in Washington that Japan had positive inflation expectations for 20 years but still ended up deeply mired in deflation.

Yellen did nevertheless cite well behaved inflation expectations as one of the reasons the low inflation is unlikely to persist for much longer. But the base case more or less is that it just seems unlikely and may have bottomed out if growth is picking up from here, especially amid a stronger second quarter after such a limp first quarter that may have masked the underlying drivers to a modestly rising inflation.

Lower energy prices, for instance, as well as “outright declines in core import prices of the last few quarters” are likely to prove “transitory” even if they didn’t last year. Anecdotally, some Fed officials are already picking up increasing affirmations from businesses in their Districts that while their pricing power is still quite limited, they are feeling more optimistic it is coming and are planning along those lines.

But above all, Fed officials are counting on better wage gains through this year to be the main bulwark against the low inflation risk. Indeed, if wages fail to show sustained gains at a pace quite a bit better than the current 2% plus or so, it may deprive the economy of its main engine to demand growth as well as the counter to turn the tide of low inflation.

What’s more, in contrast to recent academic assertions that it is only the short term unemployment numbers that matter, or the pockets of pundit patter that wages are already growing so quickly it threatens accelerating inflation, the majority of the FOMC is sticking to the belief that the lack of noteworthy wage gains so far is telling them considerable labor market slack remains. And while wages certainly look to have bottomed and are moving in the right direction, a majority of the FOMC will tend to look through any upcoming wage upticks until they see that they are sustained.

Wages may be the middle premise between unemployment and prices but in the near term, the linkage has been weakened, with a flattened Phillips Curve, at least for now.

September, and Yellen Repositioned

With that in mind, we expect the March statement will serve as the FOMC’s consensus and guidance template for several more months before any major changes to Fed communications until there is, hopefully, a bit more clarity in the sustainability and pace of growth and whether inflation is finally adhering to its modeled behavior.

The FOMC meeting next week is far too early to provide any such clarity, so we expect little to no substantial changes to the statement or the forward guidance. The data may break decisively in one direction or another by the time of the mid-June or late-July meetings, and both meetings could find either the markets repricing for quicker rate hikes if the second quarter comes in as strong as seems likely, or some within the Committee pressing for a more muscular policy response if the low inflation likewise persists against expectations. The rate dots in June could prove worth buying tickets to see.

But we rather suspect the FOMC, unless the data is overwhelming, will err on the side of resisting a substantial shift in its guidance or policy stance until its September meeting when it will have the summer of data to better discern the growth and inflation trends. The end of QE purchases and next phase of policy will by then also be squarely in sight.

And for all the hit and miss of the SEP dot plots, the FOMC will at that meeting be unveiling its 2017 year end projections for fed funds, giving the market its first taste of just how gradual the projected rate trajectory is really projected to be in what would be a third year of a tightening and the seventh year of the economic expansion. That alone will make September eventful.

One last point. For all her dovish inclinations, Yellen is at heart a pragmatic rather than ideologically-driven dove who believes inflation is simply a low risk for now, not that it doesn’t matter. So in her speech last week, Chair Yellen’s unmistakably dovish accent may have been on low inflation risks and the still considerable slack in the labor market, but she was nevertheless careful to hue closely to the FOMC consensus reached at their March meeting.

The takeaway was ultimately not whether she was as dovish as expected, but that policy going forward will be kept flexible enough to respond to any deviations in the forecasted path of the recovery. So she paid due deference to the risks, however low in the near term, that inflation could rise faster and higher than projected.

And she was equally careful to avoid any language suggesting a willingness to overshoot the 2% inflation target, and even avoided any explicit reminder at all that the 2% is not a ceiling. She instead kept to a more neutral sounding “two-sided” approach when it comes to the inflation target.

The FOMC is, after all, structured to get to a consensus on a policy decision, but not necessarily for the same reasons. And so Yellen’s repositioning ever so slightly to a “center-left” dovish stance will serve her well in building a consensus on the near-term policy path and guidance over the course of the next few FOMC meetings.

That is likely to prove just as important to navigating those “twists and turns” of the economy as it is for the Fed to act as an automatic stabilizer to the markets.

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