Fed Focus

If the Fed Could Turn Back the Hands of Time

Perhaps that’s something The Maestro might have thought he could do, but the members of the Federal Reserve are showing considerably more humility these days. When you read their words, it seems they are by and large trying to do their work, and in a stretch when possibilities formerly known as curiosities, like the Zero Lower Bound, hopped out of theoretical research papers and onto their plates.

In a recent interview, David Beckworth asked St. Louis Federal Reserve Bank President James Bullard if, could they start all over again, members of the FOMC might consider nominal GDP or price level targeting instead of the current dual mandate of stable prices and hard-to-define full employment, Bullard’s careful response was, “I think…from just a theory basis, I think there is more sympathy than there would have been a few years ago,” and added we aren’t there yet. He himself is more sympathetic than he once was.

Inflation? Follow the Trend…

Bullard brought up the question–what drives inflation?—as a key issue today, noting that, “…the answer you get from various angles is always the same: that inflation doesn’t seem to be related to the variables that we think it should be related to.” Although he advances inflation expectations as one of the stronger contenders, even that isn’t particularly well correlated with inflation. (He also likes the idea that the central bank target moderates expectations, while the bank drives the ‘flation car.)

The Phillips Curve seems to have lost its swag, Bullard maintains it never had much, and the (unorthodox and troubled) fiscal theory of the price level—that prices are determined by government debt and fiscal policy, with monetary policy playing a muted second fiddle—“leads to a lot of confusion about what is being said.”

A funny thing about the Phillips Curve: it’s been roundly questioned since it was knee high to a grasshopper. Just six years after A.W. Phillips laid it out, Milton Friedman and fellow monetarists pointed out various issues. To Friedman, it had a basic defect, the inability to distinguish between nominal and real wages, and held only in the short-run and when inflation and expectations were steady. The economics of the coming decades further tarnished the curve’s reputation.

A bit simplistic but, of course, if the Phillips Curve were truly robust, there would be no such thing as stagflation; we’d be in a naturally correcting environment. Yet in the 1970s unemployment increased along with inflation, and in the 1990s unemployment and inflation fell together. The many other economic factors that affect pricing, including tight competition, supply shocks, a greater central bank presence, and changes in the make-up of the labor market, over-power the logical connection between low unemployment and inflation.

“Deflating inflation expectations,” a recent study by Stephen Cecchetti, Michael Feroli, Peter Hooper, Anil Kashyap and Kermit Schoenholtz, suggests we should pay less attention to expectations and slack and focus instead on trend. They argue that while inflation expectations do correlate with the trend, it’s a misleading relationship because as inflation moves, expectations move with it. They point out that if inflation is moving at 2%, most will expect it will continue to do so, and will be right. They suggest instead we compare the change in inflation expectations to the change in inflation. That doesn’t work so well: changes in inflation expectations “tell us nothing” about changes in inflation.

Since inflation is currently a bit below the Fed’s target, and long-term inflation closely follows the past few years’ average, they suggest the Fed will likely need to allow a short, modest overshoot to get us to 2%.

But Bullard also points out that in 2012, when headline and core inflation were right on target, he thought the Fed’s “work was done,” but then inflation began to slip, which he has noted was happening again in the spring. That overshoot may prove elusive.

…and get rid of Core PCE

Bullard suggests the core measure of PCE should be “thrown out.” First, he is not willing to go back to his constituents and say, “We stabilized prices, just not the ones you have to pay the most often.” Second, one of his colleagues looked into food prices and found that for some stretches they are the least volatile of all components. Bullard called it “kind of comical” that we’re throwing them out because they were so volatile in the 1970s. Third, core inflation “sunk a bit, maybe a couple of tenths on a y/y basis,” when energy prices fell in the 2014, and have since reversed course. That’s because there are core components that are heavily affected by movements in energy prices, so the effect is still in there.

Bullard favors the Dallas Fed’s trimmed mean measure, running at 1.5% in May, but since so many models were built on core prices, he doesn’t think there is much will to recalibrate them all. We’d say this is not a good reason not to work to improve such an important measure, but it may be an overwhelming one. Perhaps that argues for nominal GDP, which washes out any issues with how inflation is forecast and tracked.

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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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