How Can a 3½% Unemployment Rate Be Consistent with 2% Inflation?

Powell’s remarks today were an exposition of his views on monetary policy strategy today and, second, a  defense of that strategy. He starts, in effect, asking how 3½% inflation can be consistent with a 2% inflation rate, participants’ median projection for 2020. Then he asks a more provocative question: If there is no inflation problem, why is the FOMC tightening at all?” That previews the question the Committee will have to address when the funds rate nears its estimated neutral level. His answer to the first question is “this time is different,” an idea I have written about. The stars, specifically u* and r*, are now estimated to be much lower than in the past, and there is considerable uncertainty about those estimates. This is what shapes the current strategy. He answered the second question, up to a point. The FOMC should keep raising the fund’s rate until it gets to its estimated neutral level. But why should the Committee tighten beyond the neutral rate?  He doesn’t answer that question, but the Committee will have to when the fund’s rate gets to r*. What makes this confidence so interesting is that a paper by Board staff reaches a much different conclusion. Work it out! 

Provocative Questions: What Do They Tell Us about Policy? 

Powell starts the speech by setting out two questions: 

1. With the unemployment rate well below estimates of its longer-term normal level, why isn’t the FOMC  tightening monetary policy more sharply to head off overheating and inflation? 

2. With no clear sign of an inflation problem, why is the FOMC tightening policy at all, at the risk of choking off job growth and continued expansion? 

This Time is Different 

I previewed his answer in my recent commentary: “Is This Time Different?” The NAIRU and the neutral fund’s rate are not only lower, but the estimates of them are very uncertain, the Phillips curve is much flatter, and inflation expectations are better anchored at 2%. As a result, the message is, “Don’t overreact”—to a decline in the unemployment rate below the estimated NAIRU or to a modest rise in inflation. Let the data speak and inform you about the level of the NAIRU. And with respect to inflation, the flat Phillips curve and anchored inflation expectations reduce any cost of overshooting. 

Another point Powell makes is that even if inflation remains low, maintaining interest rates low for too long can lead to threats to financial stability. This is a recurring theme in Powell’s talks. Indeed, whenever he talks about the problems associated with raising rates too slowly, he mentions both the risk of too-high inflation and the threat to financial stability. We believe that Powell sees a greater role for monetary policy in guarding against threats to financial stability than most other members of the FOMC. 

In any case, the FOMC is wagering that the NAIRU might be lower than the current estimate, that inflation  expectations will remain anchored if inflation moves above 2%, and that a flat Phillips curve will limit any  

damage. In that case, the outcome projected in 2020 is possible. Of course, forecasts are often wrong. Our forecast, by the way, is that inflation will be 2.3% in 2020, and rising. 

Go Directly to Neutral and Then Pause 

The second question is what to do when the fund’s rate gets to neutral, in March or June next year. The inflation rate is 2% and it is projected to remain virtually at 2% through 2020, despite a decline in the unemployment rate to 3½%. So, we assume a pause in rate hikes in mid-2019. 

And If the Committee Pauses, Why Would It Resume Rate Hikes? 

A pause in rate hikes to wait and see if the inflation rate rises or inflation expectations threaten to become unmoored seems reasonable. How long must the pause last to provide sufficient time to “listen to the data”?  And what if the data come in as the Committee expects, still 2% inflation? This scenario raises the question of whether they will continue to raise rates after reaching neutral. 

Does This Make You Nervous? 

I think the logic of the current strategy makes sense and the data so far support it. But everything in place warns of recession: The yield curve, a projected funds rate above neutral, and an unemployment rate far below the estimated NAIRU. So, this is a bet on “this time is different.” Of course, if the data disconfirm the forecast, especially for inflation, the Committee will adjust. 

There is still a case for the Committee to go modestly above neutral. With the unemployment rate so low and the possibility that inflation will move only a bit more above 2%, going above neutral is an insurance policy,  risk management. It tells the market that the FOMC will lean against an inflation overshoot, but only modestly,  and that it is willing to see it remain above 2% for a few years. 

The Reaction Function Has Changed 

Simple policy rules are a tool to understand the policy. So, given the above discussion, has the FOMC’s reaction function changed? Powell addressed this explicitly, but it follows his remarks. In two recent notes (Is This  Time Different? and Reverse Engineering the FOMC’s Policy Rule), I argued that there has been a dramatic shift in the FOMC’s reaction function. It’s not the balanced-approach rule anymore. The coefficient on the unemployment gap isn’t 2.3, but much closer to zero. The distinguishing feature of monetary policy recently is how little policy response there has been to the decline in the unemployment rate to well below the estimated NAIRU.  

Powell and the Staff Disagree 

The Erceg et al. paper is a wonderful example of an independent staff and a Chair who can be independent of the staff. My takeaway from the paper was that, even with uncertainty about the NAIRU, the FOMC should continue to respond aggressively to declines in the unemployment rate, with the balanced-approach rule performing well in the paper’s tests. My favorite quote: “Two economists, three opinions.” 

Dovish, Very Dovish 

Powell is very much toward the dovish end of the central banking spectrum. However, in this Committee,  shaped importantly by Yellen, he is closer to the center, though still dovish. Hawks worry more about inflation and are more inclined to be preemptive when the unemployment rate falls so far below the NAIRU. Doves are more in the “wait and see” camp. That’s where Powell is. The test will be when the fund’s rate gets to neutral.

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