New signals of a steady Fed path higher

| August 24, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Fed Chairman Powell has taken a middle-of-the-road path so far, tending to find consensus rather than pushing the FOMC in one direction or another.  But a new Fed staff paper, conspicuously released just before Jackson Hole, sheds light on Powell’s current thinking. With inflation reaching the Fed’s 2% target and unemployment and growth suggesting overheating, he is likely to support tightening Fed policy to neutral sooner rather than later.

Weighing unemployment and inflation

Doves on the FOMC have argued that since wage and price inflation are not exploding higher despite low unemployment, the natural rate of unemployment must be lower than previously thought. This argument has clearly been influential, as FOMC median projections of the longer-run unemployment rate have fallen steadily over the past five years by more than a full percentage point.  Of course, the actual unemployment rate has fallen even faster, and despite a lower estimate of the longer-run equilibrium, the current unemployment rate is seen by most on the committee as clearly suggesting that the economy is beyond full employment.

However, several of the doves have been unimpressed by the sinking jobless rate.  They have suggested that since the FOMC does not know with confidence where the natural rate of unemployment is, it should ignore unemployment and resource utilization altogether and set policy based exclusively on the performance of inflation relative to the Fed’s 2% target.

The Fed is sensitive to the natural unemployment rate since poor estimates of it led to one of the central bank’s worst policy mistakes. A Fed staff paper written by Athanasios Orphanides showed that the Fed maintained a policy that was persistently too easy in the 1970s because officials thought that the natural rate of unemployment was 4% when it was really closer to 6%.  Their error was not evident in real-time but only became obvious later, as key economic data were revised. Fed Chairman Powell recently laid out this view in his Jackson Hole speech. The runaway inflation that developed in the 1970s is widely considered one of the Federal Reserve’s worst mistakes.

Fed Board staffers recently addressed the relative importance of weighing unemployment and inflation by asking (here) which monetary policy rule would work best in the current environment.  They used the FOMC economic projections as a baseline economic forecast and then subject the economy to random shocks based on historical experience.  They then used their economic model to test three different monetary policy rules.  One is considered a balanced approach, the 1999 version of the Taylor Rule, where the weights for unemployment and inflation are essentially equal.  Then, an alternative is considered where the unemployment rate gap is downweighted and essentially only inflation counts.  A third alternative puts a very low weight on inflation and a higher weight on the unemployment gap.

The Board staffers found that of the three rules, the rule that focused almost exclusively on inflation performed worst – and by a wide margin.  As a result, the paper concludes that the FOMC will probably need to consider whether unemployment is above or below estimates of the equilibrium rate, even though these estimates may well be wrong and at a minimum are highly uncertain.

The intuition behind these results is relatively simple.  If the only source of uncertainty regarding the economy were the level of the equilibrium unemployment rate, then focusing exclusively on inflation would make some sense.  The problem for this approach is that big errors in estimating the natural rate of unemployment are relatively infrequent, and, instead, most of the shocks that hit the economy are garden-variety positive or negative shocks to economic growth.  If the policy rule largely ignores these shocks (because it puts little or no weight on the estimated unemployment gap), it will not respond appropriately.  In the current environment, when inflation expectations appear to be firmly entrenched near the Fed’s 2% target, inflation will be relatively stable, which means that the policy rule will dictate a funds rate target that rarely moves much, even in the face of substantial economic shocks.  Indeed, even in the scenario where the Fed is estimating the natural rate of unemployment is higher than it actually is, the exact case that the doves are making, the rule that focuses only on inflation does the worst of the three.

In fact, the Board staff research found that the rule that put an especially high weight on the unemployment gap performed best, even outpacing the balanced approach baseline.  To be fair, I would add a caveat here: the Federal Reserve models that are used to estimate the response of the economy to shocks is essentially a Phillips Curve-based model where inflation is thought to be driven mainly by the level of resource utilization, i.e. whether the labor market and more generally the economy are loose or tight.  Sure, the Phillips Curve is estimated to be far flatter today than it was in the 1970s, but the model is still driven by that relationship.  Thus, it should come as no surprise that the unemployment-rate-driven rule performs best.

Turnabout is fair play

The new paper, a signal of the debate going on inside the Fed, suggests that the Board staff is taking a relatively consistent approach while the doves on the FOMC are not.  In the early years after the 2008 financial crisis, economists were puzzled that inflation failed to decelerate by as much as Phillips curve models suggested.  Doves on the committee, most notably Vice Chair and eventually Chair Yellen, pushed for models and policy rules that put greater weight on high unemployment, such as replacing the original 1993 Taylor Rule with the 1999 version that doubled the coefficient on the unemployment gap term.  In general, staff research supported such approaches.

Now, the situation has reversed.  Inflation is still surprisingly steady despite a big swing in the unemployment rate gap beyond full employment.  Doves on the FOMC, because they want to conduct a relatively easy monetary policy, have abandoned the framework that they favored in the early part of this decade and are now arguing that the FOMC should only pay attention to inflation.  In contrast, the work of key Fed staffers suggests that the unemployment-rate-heavy approach works best, whether the unemployment rate is above or below the natural rate.

This turnabout is ironic.  For decades, hawks have pushed for a single mandate focused on inflation while doves argued that the dual mandate was best because the Fed needed to also consider unemployment.  Now, all of a sudden, the hawks are interested in the unemployment rate because they fear that the economy is overheating, and the doves want a single inflation mandate.  It’s enough to make your head spin.

Bottom line

Chairman Powell is likely to support moving the Fed’s policy stance to neutral sooner rather than later. After the funds rate reaches neutral, the Fed’s next moves are harder to foresee.  The new staff paper, conspicuously released just before Jackson Hole, suggests that Powell and the Fed staff are inclined to resist dovish arguments to ignore evidence of overheating and go much slower with rate hikes. Instead, Powell looks inclined to march steadily higher.

Chairman Powell’s Jackson Hole speech referenced the recent Fed paper, though he read it somewhat differently than I did.  His takeaway was that “no single, simple approach to monetary policy is likely to be appropriate across a broad range of plausible scenarios.”  As was more generally the case in Powell’s speech, the chairman appears to favor setting policy based on “feel” rather than following any systematic model or rule, which sounds great in theory, but presents all sorts of risk that the Fed will veer off track if it fails to accurately estimate key equilibrium values such as the neutral funds rate or the natural rate of unemployment.

john.killian@santander.us 1 (646) 776-7714

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