Clarida: Likely Favors Four Hikes in 2018

Richard Clarida is reported to be a leading candidate (along with Larry Lindsey) for Vice Chairman of the  Federal Reserve Board. And he checks all the boxes: A Ph.D. and a highly respected scholar; an expert on monetary policy; public policy experience in the Treasury and private sector experience. A perfect complement to Chairman Powell. He is a centrist whose views on appropriate policy. y depends on the circumstances. Today,  he sees the unemployment rate well below the NAIRU and still falling while inflation is expected to head toward 2%. He questions participants’ projections that show unemployment below the NAIRU and still falling and, yet, inflation not overshooting the 2% objective and the fund’s rate not moving above its neutral level. This places him on the hawkish side of the Committee. We expect that, as a result, he would favor four hikes in 2018. 

The Full Package: Scholar, Public Policy Experience, and Market Savvy 

We initially saw Clarida as a competitive candidate for Fed Chairman.1 Clarida is a Professor and former chair of the economics department at Columbia University. He is also Chief Global Strategist and a Managing  Director at PIMCO. He is a leading contributor to the modern world of macroeconomic theory, in the form of  New Keynesian Economics and DSGE models, focused especially on the implications of these models for the conduct of monetary policy.2 He also has senior-level policy experience in the G.W. Bush Administration as  Assistant Secretary of the Treasury for Economic Policy and Council of Economic Advisers in the Reagan  Administration. His experience at PIMCO allows him to translate his work as a scholar to understand global fixed income markets, exchange rates, and monetary policy at major central banks. So, he would bring that global perspective to the FOMC.3 He writes regularly about U.S. monetary policy. So, he has a vast paper trail and we, therefore, know more about his views on current monetary policy issues than most other nominees.  

1 As an interesting side-note, Powell was nominated by Obama to be a governor after Rich Clarida took his name out of consideration.  Now, they could both be part of the leadership of the Board and the FOMC. Indeed, if Clarida had become Governor, rather than Powell,  he likely would have been first in line to become Chair.  

2 “The Science of Monetary Policy: A New Keynesian Perspective,” Richard Clarida, Jordi Gali, Mark Gertler, NBER Working Paper No.  7147, Issued in May 1999. 

3 See Clarida, Richard H. “The Global Factor in Neutral Policy Rates: Some Implications for Exchange Rates, Monetary Policy, and Policy  Coordination,” National Bureau of Economic Research Working Paper No. 23562 (June 2017), http://www.nber.org/papers/w23562.  Presented at BIS Annual Conference on 23 June 2017: http://www.bis.org/events/conf170623/clarida.pdf 

Clarida’s Framework: New Keynesian Model 

He is a leader in the formulation of the New Keynesian Economics (NKE) and on the use of DSGE models to study optimal monetary policy. Perhaps, the most distinguishing feature relative to the model we use and most FOMC participants has in mind is that it is highly mathematical, and macroeconomic regularities are explicitly derived within the model based on optimizing behavior of economic agents, and monetary policymakers are modeled as seeking to minimize a loss function, with losses associated with deviations from the FOMC’s dual mandate. Perhaps, most importantly, he has brought the Keynesian framework of sticky prices  (output determined by aggregate demand in the short run) back to academic respectability, with monetary policy substituting for price flexibility in bringing the economy to full employment. Still,  there is little new in the NKE that a monetary policymaker needs to know from my perspective. They can do well with a dynamic  IS curve, a Phillips curve, and a (forward-looking) monetary policy rule.4 

A View of R-Star: The New Neutral 

Clarida got an early start along with his PIMCO colleagues, on the concept of a new normal; that is, the new normal for the neutral fund’s rate. Along conventional lines, he attributed the decline in r-star to lower potential growth. His estimate is tied closely to the work of Laubach and Williams, updated in Holston-Laubach Williams. Today, his nominal estimate is 2%-2½%, lower than participants’ median estimate of 2¾%. Like  Laubach and Williams, he does not distinguish between two r-stars, a current r-star, and the normal or long-run r-star. Just one! The lower r-star today is simply the “new neutral.”5 

Clarida: Hawkish Side of Center  

Is he a hawk or a dove? The answer is neither. He is a centrist whose vote would depend on the circumstances. Today’s circumstances–an unemployment rate well below the NAIRU and still falling, stronger momentum into 2018 to be reinforced by significant fiscal stimulus, and a Phillips-curve-based inflation forecast that has inflation headed toward 2% this year, today he is on the hawkish side of center. Given his modeling framework, the fiscal stimulus coming this year from the tax legislation, and presumably also from the budget, will move him toward believing that a faster pace of rate hikes would be appropriate than otherwise.  

Clarida’s Likely Policy Inclinations  

1. He has said the Committee may have remained too accommodative for too long so that normalization was overdue. A more hawkish view, if the only relative to the extraordinarily dovish policy the FOMC  followed. That suggests he wants to catch up, is concerned about falling below the curve, and worried about the higher probability of a recession.  

4The overwhelming difference, in my view, between New Keynesian Economics and Old Keynesian Economics is that the latter assumes prices are sticky and the latter goes through a lot of work and mathematics to develop a theoretically grounded explanation of why prices are sticky. Also importantly, NKE assumes rational expectations, or model-consistent expectations, or, as some would say,  clairvoyance. 

5 Fortunately, the two r-stars have almost converged as participants’ median estimate has almost converged to the Holston,  Laubach, and Williams (HLW) estimate.

2. He believes in forward-looking, or forecast-based, monetary policy. A more forecast-based monetary policy, and one based on the Phillips curve, put him with the consensus that policy should be driven by the forecast that inflation is headed to 2%, not the recent data, showing a slowdown. That means proceeding with a steady, gradual pace of rate hikes.  

3. He thinks the normalization of the balance sheet is being handled well. While I don’t think he has said it, we expect he is with Powell in favoring the current operating framework and as a result a relatively large normalized balance sheet.  

4. His estimate of the nominal r-star is 2%-2½%, below the 2¾% median estimate of participants. This tilts to the other direction, at a slower pace than otherwise, as it implies the FOMC has less to go before reaching the neutral rate.  

5. He sees an important inconsistency in participants’ projections, one which we have emphasized.  Participants expect the unemployment rate to fall eight tenths below the NAIRU and yet do not project that inflation will overshoot the 2% objective or that the fund’s rate would have to be raised above the neutral rate, as in recent expansions. Thus, he seems more concerned with falling behind the curve. This puts him on the more hawkish side of the center. 

Clarida says that Yellen has left Powell with two immediate challenges, what he calls “destination” questions:  

1. Where is r-star and have fast should the FOMC get there?  

2. What should be the size of the normalized balance sheet, tied up with the decisions about the long-run operating framework?  

The Role of a Vice Chairman 

As part of the so-called Chairman-Vice Chairman-New York troika and reflecting his expertise in macro and monetary policy, Vice-Chairman Clarida would have Powell’s ear to a greater degree than other governors and, of course, presidents. And, the combination of Powell and Clarida even makes it more likely that Chairman  Powell, backed by Vice-Chairman Clarida, could go beyond building a consensus to, at the margin, influencing the consensus. 

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