Governor Brainard recently set out the intellectual case for caution about further hikes in the fund’s rate, including, implicitly, caution about a December hike.1 The key consideration will be the assessment of the underlying inflation rate at that point (see What Will It Take to Raise Rates in December?). Most other participants are also in a wait-and-see posture, based on their uncertainty about what the underlying inflation rate is. Brainard’s case for caution touches on almost all the questions about the Phillips curve we discussed in a recent commentary (see Trouble with the Phillips Curve). All the concerns that she raises are important, and all will be in play at the December meeting. While her remarks indicate she is still in a wait-and-see posture concerning December, she is certainly at the dovish end of the Committee and will need a lot of convincing to support a rate hike. Put her down as firmly in the no camp for December at this point, as she was in June. Concerning the 2017 dots in September, she will likely have a lot more company.
She notes the disconnect between the real side and the inflation side of the FOMC’s mandate: “What is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization.” The unemployment rate is low, indeed lower than in the pre-crisis period when inflation was above 2%. And yet inflation has been below 2% for five years, and arguably now is closer to its cyclical low than the 2% objective. She notes that the NAIRU may have declined slightly, but she doesn’t see this as an important point: The unemployment rate gap was near zero before and now is slightly negative. This disconnect is her point of departure. The question is why.
Alternative Models of Inflation Dynamics
We noted in our commentary research that focuses on time series models of inflation in which labor utilization is not a major factor influencing the underlying trend. Brainard references this literature: “In many of the model’s economists use to analyze inflation, a key feature is ‘underlying,’ or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of like the slow
moving trend that exerts a strong pull on wage and price-setting and is often viewed as related to some notion of longer-run inflation expectations.” She cited recent research suggesting that this underlying trend may have fallen substantially: “One model that has been used by a variety of researchers suggests that underlying trend inflation may have moved down by perhaps as much as 1/2 percentage point over the past decade.”
1 Governor Lael Brainard, “Understanding the Disconnect between Employment and Inflation with a Low Neutral Rate,” at The Economic Club of New York New York, New York, September 05, 2017.
A Decline in Longer-Term Inflation Expectations
She notes that longer-term inflation expectations are closely associated with the notion of an underlying trend. She interprets the Michigan Survey as suggesting longer-run inflation expectations may have fallen ¼ percentage point over this period. She also gives some weight to market-based measures, pointing out that ten-year-ahead inflation compensation based on TIPS yields is ¾ percentage point lower than before the crisis.
She notes that it is not hard to understand why longer-term inflation expectations may have moved down since the financial crisis: experience over this period, specifically the prolonged period of inflation below the objective. In our commentary, we highlighted this question in relation to the Phillips curve model of inflation dynamics and noted that, if inflation remained near its current level, this would be front and center at the December meeting. She also pointed out another possible reason: A lower neutral funds rate implies hitting the effective lower bound more frequently, resulting in more instances of the Fed being constrained from raising inflation to its objective.
The Flat Phillips Curve
As we noted in our commentary, a very flat Phillips curve is the real killer with respect to Phillips curve dynamics. And this is an important part of her story: “In today’s economy, there are reasons to worry that the Phillips curve will not prove very reliable in boosting inflation as resource utilization tightens…The Phillips curve appears to be flatter today than it was previously.” It would take a very large further decline in the unemployment rate to push inflation to 2% on a sustainable basis.
A Decline in, and Slower Return to, the Neutral Funds Rate
Brainard leaves no stone unturned in her case for caution. She includes a number of other reasons for caution, considerations affecting the appropriate path of the fund’s rate not directly related to the assessment of the underlying inflation rate. She noted, for example, that participants’ median estimate of the longer-run neutral fund’s rate has fallen substantially over this period and that the Laubach-Williams estimate of the current real neutral rate is actually slightly negative. In addition, she says that the neutral fund’s rate “is likely to rise only modestly in the medium term.” In that case, we’re not far from the neutral rate, so gradualism is called for.
She also notes that balance sheet normalization is raising the term premium, which will reinforce the tightening of policy via short-term rates: “Typical rules of thumb suggest that such an increase in term premiums would imply a decrease in the short-run neutral rate of interest.” In addition, the normalization of foreign central bank balance sheets will add to this effect, and “the current downward pressure on longer-term interest rates from foreign spillovers will abate.”
These factors combine so that her “current expectation is that the short-run neutral rate of interest may not rise much over the medium term.” This calls for a slower pace of rate hikes than otherwise.
Underlying Inflation and the Buffer
Brainard then connects her discussion of inflation dynamics and the neutral fund’s rate to argue for caution with respect to further rate hikes. Because of the effective lower bound (ELB) on the fund’s rate, a lower neutral funds rate means the FOMC can’t lower the fund’s rate as far relative to neutral as before; there’s a smaller “buffer.” The buffer of course is the real neutral rate plus underlying inflation. As a result, when
inflation is stubbornly below its objective, this is another reason why “there is a high premium on guiding inflation back up to target.”
A Symmetric Inflation Objective
Indeed, she goes further, saying, “I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time. In my view, this is the clear implication of the symmetric language in the Committee’s Statement on Longer-Run Goals and Monetary Policy Strategy.” So, in Brainard’s view, the risk that caution will lead to higher inflation is less of a concern.
The Other Side: Transitory Shock to Core Inflation
If, as many forecasters assume, the current shortfall of inflation from our 2 percent objective indeed proves transitory, further gradual increases in the federal funds rate would be warranted, perhaps along the lines of the median projection from the most recent SEP.
We highlighted the issue of price level shocks as critical in the assessment of the underlying inflation rate. The 12-month core PCE inflation rate is usually taken as a measure of underlying inflation–except in special cases, perhaps like today! It was 1.8% or 1.9% from August last year to February this year, a long enough period to give some confidence that this was the underlying rate. And if this was the case, the FOMC had virtually achieved its inflation objective. Many FOMC participants, including Yellen, have noted that transitory price shocks may have lowered core inflation, particularly in March.
If this is the case, perhaps underlying inflation is well on its way to the 2% objective. But those transitory effects will remain in the 12-month measure of core inflation the Committee will have in hand in December, and indeed even in March. That leaves the key question at the December meeting as to what the Committee judges the underlying inflation rate to be, and, if it’s closer to 2%, how much confidence the Committee has in that view. This is a view that has a lot of support among participants. Still, as Dudley has said, “the jury is still out,” and, as Yellen has said, “there could be more going on there.” Brainard seems more skeptical of this view. While she allowed that temporary factors “are pushing down inflation to some extent this year,” she pointed out that other temporary factors boosted inflation last year.
Bottom Line: Wait and See and the Case for Caution
The main issue in December will be the assessment of the underlying inflation rate.
I am concerned that the recent low readings for inflation may be driven by depressed underlying inflation, which would imply a more persistent shortfall in inflation from our objective. In that case, it would be prudent to raise the federal funds rate more gradually. We should have substantially more data in hand in the coming months that will help us make that assessment.
So the bottom line is that whether or not Brainard will support a hike in December remains to be determined. It depends on her assessment of the underlying inflation rate. All agree on that. But there are also other considerations that would tilt Brainard toward caution, toward wanting to delay: She thinks the current level of the fund’s rate is likely already close to the short-term neutral rate and doesn’t expect the neutral rate to rise much over the medium term, in part because of balance sheet normalization.
But how to get inflation higher? That’s the question for monetary policymakers. She says, in the end, it’s about raising inflation expectations: “For all these reasons, achieving our inflation target on a sustainable basis is likely to require a firming in longer-run inflation expectations–that is, the underlying trend.” This simply reflects the logic of the Phillips curve: If the unemployment rate is already at a level consistent with 2% inflation and any shocks restraining inflation are transitory, all that is needed is to raise and stabilize inflation expectations at a level consistent with the 2% objective, subject to working through any inertia in inflation.
The question is how monetary policy could accomplish that. The only way to do that, in our judgment, is to be very cautious about raising rates and hope for the best! But if core inflation is really stuck at 1½%, and the Phillips curve is very flat, caution alone may not get the job done. And the FOMC can’t talk up inflation expectations. A conundrum!