Brainard has been the intellectual leader of the more-dovish FOMC members, those whom we have called the “show me the inflation” camp. This camp is more backward-looking and data-dependent, in part because they are suspicious of forecast-based policy, especially about the reliability of the Phillips curve as a guide to policy. The centrists on the Committee, while giving attention to disappointments in the inflation data, have made policy decisions based on their forecast that inflation is headed to 2% sooner rather than later. The incoming data are increasing their confidence in that forecast. Forward-looking policy also takes into account the strengthening in aggregate demand expected as a result of fiscal stimulus. The dovish camp has seen two or fewer hikes as appropriate this year. The forecast-based camp believes three to four hikes are more appropriate. Brainard presents an excellent summary of the factors that are pushing policymakers, in general, to see a quicker pace of hikes as appropriate: synchronous global growth, improved financial conditions, fiscal stimulus, and further declines in the unemployment rate to perhaps a historically low level. Presumably, all these considerations will be reflected in revisions to her macro and rate projections at the March meeting. And, while she is still cautious about the underlying rate of inflation, our most important takeaway is that she now sees more upside risk than downside risk, even talking about the prospect of an overshoot of the 2% objective. We now believe her dot for 2018 in March will likely be at three. She is unlikely to dissent.
From Tailwinds to Headwinds
Brainard begins by summarizing the difference in the circumstances that previously had suggested more caution in raising rates and the circumstances today.
Many of the forces that acted as headwinds to U.S. growth and weighed on policy in previous years are generating tailwinds currently.
▪ Previously, demand abroad was anemic; now, there is synchronized global growth. ▪ The dollar had appreciated, putting downward pressure on import prices; more recently, the dollar has depreciated.
▪ Previously, lower oil prices were damping business fixed investment; more recently, oil prices have risen.
▪ From mid-2014 into 2016, financial conditions tightened as equity prices were flat and the dollar appreciated; they eased thereafter and today financial conditions remained very accommodative, even with the recent tightening in financial conditions.
▪ Earlier in the recovery, the economy faced fiscal restraint; today the economy is poised to experience a powerful fiscal stimulus.
Brainard appears to have become more forecast-based in her assessment of appropriate policy. As a general principle, when the data begin to confirm the forecast, or there are sharp changes in conditioning variables that alter the forecast, place more emphasis on the forecast.
Still Cautious About Inflation Prospects
In contrast to the change in circumstances related to growth, inflation has remained subdued for some time, and she emphasized that is still running below the 2% objective. This has been the principal reason for
Brainard’s dovish views. Indeed, inflation is not only still running below 2%, but it has also recently softened. She acknowledged that yes, some transitory forces are in play. But she was also concerned about more persistent forces that might leave underlying inflation below 2%.
There are two considerations which have been reinforcing her concern that inflation continues to lag:
▪ Questions about the stability of long-term inflation expectations. It is important that monetary policy ensures that underlying inflation is re-anchored firmly at 2%.
▪ It is difficult to know with precision how much slack remains. If more workers can be drawn into the labor market, the labor market could firm further without generating inflationary imbalances.
But the Balance of Risks with Respect to Inflation Has Changed
Although last year we faced a disconnect between the continued strengthening in the labor market and the step-down in inflation, mounting tailwinds at a time of full employment and above-trend growth tip the balance of considerations in my view. With greater confidence in achieving the inflation target, continued gradual increases in the federal funds rate are likely to be appropriate…stronger tailwinds may help re-anchor inflation expectations at the symmetric 2 percent objective.
And now, she has become more focused on upside rather than downside risks to inflation.
Of course, it is conceivable we could see a mild, temporary overshoot of the inflation target over the medium term.
Importantly, and what we expect to see more generally from participants, is the emphasis on the implications for policy of a symmetric inflation target in practice, not just in principle.
If such a mild, temporary overshoot were to occur, it would likely be consistent with the symmetry of the FOMC’s target and could help nudge underlying inflation back to our target.
From Inflation Risk to Recession Risk?
Finally, she points to the risk of a recession coming from continuing declines in the unemployment rate, likely to a historically low level. This is a “getting behind the curve” story. Unemployment rate falling too far below the NAIRU, raising the risk of higher inflation and calling for a faster pace of rate hikes.
If the unemployment rate continues to decline on the current trajectory, it could fall to levels that have been rarely seen over the past five decades. Historically, such episodes have tended to see elevated risks of imbalances, whether in the form of high inflation in earlier decades or of financial imbalances in recent decades.
Then adding to the risk of higher inflation is the possibility of nonlinearity in inflation dynamics at historically low unemployment rates.
We do not have extensive experience with an economy at very low unemployment rates and cannot be sure how it might evolve.
Implications for Monetary Policy: What She Said, and What She Implied!
Continued gradual increases in the federal funds rate are likely to remain appropriate to ensure inflation rises sustainably to our target and to sustain full employment, keeping in mind that interest rate normalization is well underway and balance sheet runoff is set to reach its steady-state pace later this year.
Back to the limited information content of “gradual.” Three per year surely is. And some Committee members have said it is also consistent with four per year.
So her one sentence on the monetary policy provides little guidance about any change in her view of the appropriate pace of monetary policy in 2018.
But it is the evolving outlook that will be driving this decision, and she is, in our view, signaling a change in her view toward a somewhat more rapid rise in the fund’s rate. We had her at two hikes for 2018 in the December dots. Now, we anticipate that her 2018 dot submitted at the March meeting will be consistent with three hikes, now in line with the median dot.