Clarida: A Supply Sider

Vice-Chair Clarida today gave his first speech since joining the Board. It was a rich and revealing talk, the kind folks like us welcome. Plenty to absorb and to speculate about! Here are highlights followed by a  discussion of the implications. 

▪ He believes that at least some of the recent strength in growth has been structural: “I believe that trend  growth in the economy may well be faster…than I would have thought several years ago.” He gave serious consideration to there being a meaningful supply-side effect of the Trump tax cut. 

▪ A bit of a consistency problem with respect to the state of the labor market: He says the unemployment  rate is “at or close to mandate-consistent levels.” On the other hand, he cites and appears to be reasonably comfortable with participants’ median estimate of 4.5% for the NAIRU. So at full employment or beyond? 

▪ On balance, his comments appear to suggest that he doesn’t see the labor market as overheating. He  notes that “the increase in wages has been broadly consistent with the pickup in productivity growth that  I have just discussed, and a rise in the still-low rate of labor force participation among the prime-age  population provides scope for the job market to strengthen further without generating inflationary  pressures.” Moreover, he said, “In the past two U.S. expansions, gains in real wages in excess of  productivity growth were not accompanied by a material rise in price inflation.” 

▪ He suggests that strong growth and employment gains alone wouldn’t make him more hawkish.1 This is consistent with his views that strong growth may be sustainable and there is likely room for further cyclical improvement in the labor market. 

▪ The most important variable for him today is inflation expectations.2 Compared to his colleagues, he appears to focus more on market-based measures relative to survey measures. This may reflect his experience in the markets. 

▪ While he emphasizes that estimates of the NAIRU and r-star are imprecise, he says these estimates nevertheless provide guidance for monetary policymakers. 

▪ He focused on an estimate of r-star derived from financial markets, in line with recent comments of Powell and Brainard. He says the market-based estimate has risen to ¾%, which would put his estimate of nominal r-star at 2¾%, putting him in the central tendency of participants. 

▪ Policy is accommodative today and the immediate objective is to remove accommodation; that is, go to  neutral. 

1 “As I look ahead, if strong growth and robust employment gains were to continue into 2019 and be accompanied by a material rise in actual and expected inflation, that circumstance would indicate to me that additional policy normalization might well be required beyond what I currently expect. By contrast, if strong growth and employment gains were to continue and be accompanied by stable inflation,  inflation expectations, and expectations for Fed policy, that situation, to me, would argue against raising short-term interest rates by  more than I currently expect.” 

2 He says, “Because monetary policy operates with a lag, and with inflation presently close to the 2 percent goal, it will be especially  important to monitor inflation expectations closely‑‑using both surveys and financial market data‑‑to best calibrate the pace and  destination for policy normalization.” 

▪ Whether there will be a need to go above neutral is currently unclear, but it will not be appropriate if inflation and inflation expectations remain stable. Given participants’ projections, that might tilt toward stopping at neutral, essentially consistent with our projections.  

▪ “The risks that monetary policy must balance are now more symmetric and less skewed to the downside.” 

Clarida as Supply Sider 

Powell has given more attention to supply-side issues than previous policymakers, but he has stuck to mentioning changes as a possibility. Quarles and now Clarida have gone further. Clarida says this train has likely already left the station, with potential growth supported by higher capital spending, in turn, supported by the Trump tax cut. Participants’ median estimate of potential growth has been at 1.8%, its low point, for some time now. We expect participants’ estimate of potential growth to edge up somewhat over time. In addition, Clarida said there may be more room for the labor market to strengthen via a higher participation rate, principally because of the low participation rate for prime-age males. The potential for further increases in the participation rate, or at least a smaller decline than would have otherwise occurred because of secular trends, has been a staple of many policymakers. 

Trump must have liked what he heard 

Trump must now be happy with this appointment, at least, after apparently having buyer’s remorse with respect to Powell. Faster growth in potential (maybe), more room for the labor market to strengthen (maybe).  (Economists and forecasters use “maybe” a lot!) In any case, his views are in the “more room to go” camp despite the low unemployment rate today. Still, we expect Trump will ultimately become disenchanted with  Clarida, who after all still believes it is appropriate to raise rates further.  

The Stars 

Clarida said that, despite the imprecision of their estimates, they must remain a guide for policy. But one should not be too committed to the current estimates and should reassess them with incoming data. A tilt to what we call the “you’ll know it when you see it” camp, led by Powell. He agrees with Powell that market-based estimates should be input into estimates of r-star. 

Focus on inflation expectations 

This seems to be the most important variable to Clarida. Whether or not the FOMC should go beyond neutral will depend importantly on the stability of inflation expectations. He also gives more attention to market-based estimates than surveys, but he says market-based estimates have risen and that both are consistent with inflation expectations at 2%. 

Policy Going Forward 

He supports the recent policy of gradually raising rates to remove accommodation. If his estimate of neutral is 2¾%, as we read it, he is in line with the consensus and we have interpreted the consensus as a 25-basis point hike every other meeting through September 2019. The bias is to go higher, but his views will be shaped by incoming data on inflation and especially on inflation expectations. Based on that, we expect he will not want to go above 2¾% to 3% if his projections are in line with participants’ median. 

A Dove or a Hawk? 

Not far from the center, but dovish on balance. His supply-side focus tilts toward a dovish inclination, but the facts must bear this out. “Room to go” given a higher estimate of potential growth and possibly greater labor force participation also points to dovish. In addition, he is also apparently in the “show me the inflation” camp, 

which suggests he will be reluctant to go beyond neutral if inflation remains near 2% and inflation expectations are stable at that level. 

Recent Financial Volatility Not A Worry Yet 

Clarida suggested that the FOMC would not alter its policy course in response to recent volatility in financial markets. However, a prolonged deterioration could prompt reconsideration: “Look at a wide range of real and  macro and financial data to get a sense of where the economy is heading…financial conditions are one piece  of that but on a sustained basis.” 

An Influential New Policymaker, But Powell Still Leads 

Rich Clarida is a blessing to the FOMC, a truly outstanding economic scholar, a leader in theoretical macroeconomics, and New Keynesian economics in particular. By the way, aren’t we all now in the New  Keynesian economics camp? He also has deep experience in both anticipating and understanding developments in financial markets, which will also be valuable. He will be an extraordinary colleague on the  Board and FOMC and become a key member of the Troika, now comprised of Powell, Clarida, and Williams.  So Clarida’s views will be very influential, though as Vice-Chair he will likely support what Powell establishes as the consensus view. Powell has quickly become a thought leader within the Committee.

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