Fed Focus

Looking beyond Monetary Policy

Interpretations of Fed Governor Lael Brainard’s speech on Tuesday, May 30th, to the New York Association of Business Economists were wide ranging: some thought she has shed her dovish feathers, others that she is signaling uncertainty at the FOMC concerning the direction of monetary policy. We read her talk as a continuation of her focus on ongoing weakness in inflation despite, as she put it, the growing number of forecasters who believe the U.S. economy is at or very close to full employment. We’d like to look beyond the immediate implications for monetary policy in her talk and highlight some underlying premises. Part of that is admittedly because we think she is making important points but, hey, with rates heading up we will need to shift the conversation to the issues beyond the reach of interest rates. The sooner the better.

In her opening remarks she notes that we are currently seeing a synchronized expansion, which has moved global risks in a positive direction, and forecasts are moving up, which has broken a string of downward revisions. She is encouraged that the U.S. Labor Force Participation Rate has held steady even while facing, “what many believe to be a downward trend in demographics”; the employment/population ratio is at a post-recession high, and those working part-time against their wills is close to its pre-crisis level. The U-3 employment rate, the “official” rate, is now at its 2006/7 cyclical low, although she notes that the rate was at and below that level in the late 1990s.

If all continues to go as preliminary data for the second quarter suggest, the federal funds rate will be well on its way to neutral and the FOMC will turn its attention to the balance sheet soon. But.

Brainard quickly moves to the “tension” between the signs that we are reaching full employment, and the possibility that “tentative progress on inflation…may be slowing.” If progress on employment and the lack thereof on inflation persist, she will reassess the path currently outlined for both the funds rate and the balance sheet.

One concern is the unemployment rate, but not quite what you’d guess. What worries her is that in the past when the unemployment rate has been as low as it is currently, it has been hard for expansions to sustain themselves. With very little growth in the labor force, it’s hard to keep GDP moving. And, we’d add, even without law changes, a bellicose attitude toward immigrants could flatten what growth we are seeing, and even cause a contraction—or at least severe distress in industries like construction, restaurants, and even tech.

Brainard notes that in the past rising inflation has sounded the “death knell” for expansions, but that inflation expectations have been stable in the most recent expansions. From 1998 into 2001 core PCE inflation never exceeded 2% on a four-quarter basis, and the high of 2.4% in 2006/7 was a pass-through in import prices—in other words not a child of durable wage inflation.

She also notes the Atlanta Fed’s Wage Growth tracker showed upward movement in wages until about a year ago, but has shown little acceleration recently, the Employment Cost Index is up from a year ago, but down from two years ago, and boring old average hourly earnings are moving at the same pace they were last year. Core consumer price inflation (national accounts basis) was up just 1.5% on a twelve-month basis in the April report, well below the FOMC’s 2.0% objective, and although the most recent reports may have been depressed by upgrades to cell-phone plans, the distance to the goal is a “cause for concern.”

Take that, Phillips Curve

Calling the Phillips Curve a “less reliable guidepost” than it once was, Brainard turns to inflation expectations from the Michigan Consumer Confidence survey, which remain near their all-time low, although the New York Fed’s measure of three-year inflation expectations rose to its highest level in more than a year. Market-based measures of inflation compensation have improved, but remain below the average that ran between 2010 and 2014. She sees more signs of a slowing in inflation than an upside break, which she thinks may be the result of the non-linearity of inflation and unemployment when unemployment is so low. The flatness in the Phillips Curve is also apparent in European economies.

Brainard wonders if NAIRU is currently lower than it was, which makes sense to us, or if perhaps the U-3 is overstating the strength of the labor market. The employment/population ratio for prime age workers remains 1 point below its pre-recession level. She didn’t mention the quit rate, which is improving slowly but remains soft in many sectors by long-term standards, which we detailed recently and would argue has a lot to do with weakness in wage growth.

We put together an estimate of the quit rate between 1967 and 2000 using job leavers and short-term unemployment (the quit rate tracks those unemployed for less than 5 weeks very closely), and then switch to the Job Openings and Labor Turnover Survey’s measure, which began in 2000. Using the longer run quit rate, the current rate would be historically consistent with an unemployment rate of 6.3%; using the JOLTS period only, 5.1% Back in 2014 the quit rate was implying an unemployment rate of 7.7% instead of the 6.7% it actually was, so it’s a long standing disparity.

The wage piece of the U.S. labor market is having a tough time getting off the mat; if you put theory and ideology aside and listen to what people are saying, worker insecurity is a big deal these days, and compensation packages are far from what they once were. The Beige Book reported that employers are lifting wages to attract employees, but we don’t think that will overpower the long-term degeneration in wage structures that has occurred since the financial crisis.

Brainard didn’t change anything on her favored approach to reduction of the balance sheet, subordinated to changes in the funds rate—predictability rules at the Fed these days—and she reiterated that the balance sheet itself would come into play should the economy experience adverse surprises during the normalization process.

Revenues at the state level continue to do OK, if running below past performance. We believe that that relative weakness is itself another measure of the divergence between growth and prices evident in many data series, and Governor Brainard’s focus.

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The Return of the String

It’s been a while since we’ve read about the FOMC pushing on a string, but that string is getting renewed attention. Although there is broad consensus that monetary expansions lead to increased output and contractions lead to decreased output, in their new paper, “Gaussian Mixture Approximations of Impulse Responses and the Nonlinear Effects of Monetary Shocks,” Christian Matthes of the Richmond Fed and Regis Barnichon of Universitat Pompeu note there is little agreement on asymmetric and non-linear effects of monetary policy. (link below) That leaves two key questions unanswered. For the first, they employ the string metaphor—is a contractionary shock, pulling the string, more effective than an expansionary one, pushing the string? Second, how much does the state of the business cycle change the effectiveness of monetary policy?

The authors note that the standard approach to answering such questions, the use of Vector Autoregessions (VARS), is inherently flawed; such models are linear and cannot answer questions about asymmetrical shocks. Replacing VARS with Gaussian approximations (GMAs) the authors are able to estimate a moving average for the economy directly from the data, and then apply Gaussian basis functions in order to capture non-linear responses. Testing the GMA model against VAR results shows the former detects nonlinearities and estimates their magnitudes well.

And the string has it. On average, no matter how they identify monetary shocks, the contractionary ones have a “strong adverse” effect on unemployment, while expansionary ones have “little” effect. And the state of the business cycle does indeed play a role: when there is slack in the labor market, an expansionary shock has an expansionary effect, but in a tight labor market, an expansionary shock has no significant effect on unemployment, causing instead a “burst” on inflation. If the unemployment rate is 4%, an expansionary shock increases inflation by twice that suggested by VAR estimates. If the unemployment rate is 8%, there is no effect on inflation, probably because of downward wage rigidities. They note this is in line with the Keynesian narrative where a monetary authority working to expand an economy already operating above potential would achieve only higher inflation. (We discussed problems with how we measure potential, and its weak trajectory, in our last issue: we’re moving toward potential because the bar keeps falling.)

The authors suggest we employ their models to ascertain nonlinear effects of fiscal policy shocks. Indeed. A coherent fiscal policy would be such a shock in itself it might blow out the Gaussian models. But, joking aside, monetary policy has been pushing that lonesome string for a long time now, and if we want a more vibrant economy and the higher rates that come with that territory, we’d better try something else, something with some real pull.


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St. Louis Fed’s James Bullard: Enter the Regime

To paraphrase a wise friend, there are three things we can know about the economy: what people say it is, what we each believe it could be, and what it is. The world is too much with us on the first two, while St. Louis Fed President James Bullard et al. are reframing the third in their recent paper, “The St. Louis Fed’s new characterization of the outlook for the economy.” As was picked up by the media, the new frame suggests interest rates far lower than the conventional models.

This clear nine-page paper invited, and received, a lot of criticism. Some labeled it pessimistic, and used its publication to call for higher interest rates, while others quibbled with the veracity of the inflation scales, and used its publication to call for higher rates. The paper is clear that there are risks to the outlook, which takes the steam out of the biggest criticism, that things could change. Indeed.

But Bullard and the SL Fed are outlining a new framework for our economy and how we understand it. After a performance review, they abandoned the idea that the economy will return to a recognizable steady state and their models built on such a state, which they believe have outlived their usefulness. They now see a series of regimes that are persistent and cannot be forecast. In abandoning the single steady state, they are more in line with current cosmological thought, probably a good thing, and in replacing that state with regimes that cannot be forecast, they are moving closer to what we see all around us. In limiting the horizon to two years they are echoing CBO’s Larry Ozanne’s belief that in many cases forecasting out more than two years is a waste of taxpayers’ money.

They are making this switch now because they believe real output, unemployment, and inflation are close to the “mean outcome of the current regime.” Since they cannot predict when the track will switch, they are “forecasting” that the current regime will persist and policy will be set as is appropriate to that.

In the current regime weak productivity produces weak output, as is surely the case, and real rates remain low, as do returns on short-term government debt. Here the authors make an important distinction. Noting that the real return to capital has not “declined meaningfully,” they attribute low rates on government debt to an “abnormally large” liquidity premium, their fundamental factor, not to low real returns throughout the economy. Full disclosureperhaps we think that’s important because it’s close to what we’ve been calling a missed opportunity recently: capital investment is weak, even though it currently carries a higher return than financial assets, and that weakness flows through the economy. We’ve long argued that if we want higher rates we need more capital investment, job training, and the like.

Shifting the Fed’s dependency to regimes instead of data suggests a more coherent communication. Recently some of the secondary data streams have become more important to the FOMC’s thinking than the primary, and that needs to be evaluated in a bigger context, in this case a regime. Of course, we’re going to have to wait to find out what it all means.

In this context, the authors peg the “appropriate regime-dependent policy rate path” (get used to writing that) at 63 basis points, and the Dallas Fed’s trimmed mean inflation, their preferred measure, at 2% over their horizon. Solving a one-year Fisher equation (0.63 less 2.0%), pegs the real rate on short-term government debt at -137 basis points. That’s now r† (r dagger) to distinguish the government rate from r*. Their main difference between the prior and current outlooks: in the old all components “trended” toward values in line with the assumed steady-state outcome. Specifically, the policy rate would be 350 bps above today’s level. He notes that if the FOMC adds 25bps a year, it would take 14 years to get there.

Taking the steady-state economy off the table makes sense to us as well. That steady state was supported by such old-fashioned things as long-term capital investment, job churn, new business formation, and productivity growth, the facets of a vibrant economy. If you take the legs off a chair, you can’t expect it to stand.

It’s a relief to have the uncertainty of our world accepted, and to hear those three little words, “We don’t know,” coming through. As Janet Yellen put it recently, “I am describing the outlook that I see as most likely, but based on many years of economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so.”

You could argue that it’s scary to hear those with such power express such uncertainty, but it sure beats hearing full confidence from those who were deeply wrong about what was to come, as we did in the years leading up to the crisis.

We have long expected Bullard to come up with some original thinking and, whether you like what the SL Fed is saying or not, we have that in spades. We’ve joked that we have a soft spot for him because we believe he was the first to use “Halloweenish” in an official Fed communiqué. Sometimes you don’t know what you want until it falls into your lap.

Honk if you now know you’ve always wanted to see such a word in Fed print.

Philippa Dunne & Doug Henwood




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The Dart Lands on 2%

How did that 2% inflation rate get sanctified? Neil Irwin of the New York Times once traced the origins of the totem back to Dan Brash, a former kiwi farmer who became governor of the Reserve Bank of New Zealand in 1988. Shortly after Brash took office, the NZ parliament mandated that the central bank pick an inflation target and granted it the political independence to meet it. Working with the nation’s finance minister David Caygill (successor to the legendary Roger Douglas, whose policy of aggressive market liberalization had worldwide influence), Brash settled on 2%. The idea spread to central bankers around the world.

Should there be such a target? The consensus of those who matter for such things seems to be yes, but one important dissenter was the current chair of the Fed, Janet Yellen. At FOMC meetings in 1995 and 1996, Yellen argued strongly against adopting a formal inflation target. In January 1995, she denounced a single-minded focus on inflation at the expense of real outcomes like employment and income growth. Underscoring the point, the said that “a wise and humane policy is occasionally to let inflation rise even when inflation is running above target.” Further, the costs of inflation targeting could be high: “Each percentage point reduction in inflation costs on the order of 4.4 percent of gross domestic product…and entails about 2.2 percentage-point-years of unemployment in excess of the natural rate.” For her, there was no proof that keeping inflation low improved economic performance, making those costs not worth paying.

She developed the point a year-and-a-half later, at the July 1996 meeting of the FOMC. She reiterated that very low inflation has no demonstrable economic benefit, other than perhaps reducing tax distortions, and those problems could be addressed legislatively without incurring the economic costs of disinflation. She also touted the flexibility afforded by slightly higher inflation: it made it easier for real interest rates to go negative when the economy needs stimulus, and it also disguised real wage cuts that might be necessary in response to demand shocks or to balance labor supply and demand across sectors. Of course, inflation in 1995 and 1996 was around 3%; she thought lowering that to 2% wouldn’t hurt much, but anything beyond that would be uselessly painful. But now even 2% might seem constraining with the ZLB having become a fact of life, and one that might endure.

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Stanley Fischer on the ZLB

In a speech to the American Economics Association’s annual meeting, Fed vice chair Stanley Fischer asked some important questions and provided few explicit answers. (He admits this himself; it’s not a reader’s uncharitable judgment.) Much of it is inspired by the zero lower bound (ZLB), but Fischer’s attention roams widely around from that starting point.

His first stop is the possibility that we’re moving towards a world with a “permanently lower long-run equilibrium interest rate,” aka r*. We’ve always been skeptical of that concept, for a number of reasons. You can’t see it, and every attempt to estimate it statistically winds up with different results. Maybe there are several points of equilibrium—a high-employment and a low-employment equilibrium, for example. Or maybe something as turbulent as a modern capitalist economy has no point that’s durably stable enough to deserve the name equilibrium.

But we don’t have seats on the FOMC, so we must bracket these concerns. A number of recent empirical efforts have found that r* is close to zero, and this empirical work has found theoretical support in Lawrence Summers’ argument that we are in a state of secular stagnation. When combined with low inflation, interest rates will spend a lot of time at or near the zero line, which makes life very difficult for central bankers.

What to do? One option is to raise the inflation target from the semi-official 2% to some unspecified higher level. To Fischer, this is risky business, and it seems to hold little appeal for him. Another possibility is to adopt negative interest rates—a strategy that some European countries have experimented with—but Fischer also finds this problematic, at least in the short term.

A third approach, about which Fischer says nothing negative (unlike most of his other propositions) is raising r* through expansionary fiscal policy. “In particular,” he observes, “the need for more modern infrastructure in many parts of the American economy is hard to miss. And we should not forget that additional effective investment in education also adds to the nation’s capital.” It might be possible to manipulate the yield curve, allowing short rates to rise for the sake of normal policy and money market functioning while keeping economically sensitive long rates down. That could be accomplished through continued long-term asset purchases by the Fed and a shortening of maturities by the Treasury.

Central bankers are expected to be discreet, and Fischer is well-practiced. But occupationally adjusted, he’s calling for a more stimulative fiscal policy to counter what could be a bout of long-term economic stagnation. There’s certainly room to boost public investment: as the graph on p. 5 shows, after depreciation, civilian public investment hasn’t been this low since the World War II mobilization.

Fischer stepped out of normal central bankerly discretion to endorse raising rates to prick an asset bubble, a controversial position in the trade. While he thought macro-prudential tools might be appropriate—capital requirements, or restrictions on loan-to-value ratios—the Fed doesn’t have the freedom to wield such tools that its foreign counterparts have. So, “if asset prices across the economy…are thought to be excessively high, raising the interest rate may be the appropriate step,” he concluded. One awaits the declassification of FOMC transcripts to see what Fischer is saying behind those big wooden doors—and how his colleagues are reacting.

Although Fischer said in the speech that r* was likely to stay low “for the policy-relevant future,” he disclosed on Wednesday that the markets are wrong if they’re only expecting two rate hikes this year. Of course, four quarter-point hikes would amount to just a single percentage point, which isn’t all that far from zero.

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