“This time is different” is one of the most regretted prognostications. A more trusted prescription is: “History repeats itself.” Still, the FOMC is conducting policy as though this recovery is different. Powell said that historical comparisons might not be as reliable today. Another example is the apparent change in the FOMC’s reaction function. Specifically, the response of the funds’ rate to declines in the unemployment rate below the NAIRU has been dramatically lower than in the past. The Committee appears to see fewer costs and more benefits than previously. And they see any rise in inflation as likely to be very modest given the flatness of the Phillips curve. But there is reason to be skeptical, especially about whether the favorable outcome for inflation and the unemployment rate projected in 2020 will actually materialize and whether it would be sustainable.
The Dramatic Change in the FOMC’s Implicit Policy Rule
Our point of departure is a balanced-approach rule that the Fed offers as an example of a policy rule.1 The defining feature of this rule is the relatively large response parameter on the unemployment gap: 2.3. But, based on this rule, the fund’s rate conditional on SEP macro projections for 2020 would be as high as 5¼%, or 2 percentage points higher than the median rate projection. In a recent commentary, we reverse-engineered a rule whose prescriptions were in line with the median SEP rate projections at the time (see Reverse Engineering the FOMC’s Policy Rule). We found that the response to the unemployment rate gap was closer to zero than to 2.3.
Lower Costs of Deviating from NAIRU
Very Flat Phillips Curve
The Phillips curve has become very flat. In the Yellen Phillips curve, a one-percentage-point decline in the unemployment rate (below the NAIRU) would affect an increase in inflation of only 0.1 percentage point. Because of the inertial nature of this relationship, the effect on inflation would increase over several quarters and would round up to two tenths. A very favorable trade-off, if sustainable.2
1 See Janet L. Yellen’s (2012), “The Economic Outlook and Monetary Policy,” speech delivered at the Money Marketeers of New York University, New York, April 11.
2 Of course, the flatness of the Phillips curve bites if the FOMC wants to lower inflation back to its objective.
Anchored Inflation Expectations
Most importantly, the Committee is acting as if inflation expectations would be securely anchored at 2%, even with inflation overshooting 2% modestly. Arguably, inflation expectations have fallen below 2% during the long period during which inflation has been below 2%. But we expect that inflation expectations would rise to 2% and then remain anchored there for some time as inflation remains near 2%, overshooting slightly to 2¼% (as in our forecast). Some policymakers have argued that overshooting 2% for some time might be necessary to bring inflation expectations back up to 2%. Of course, the question here is how long is “for some time,” and, in turn, how long a modest overshoot of the inflation objective is even sustainable.
A Stable Tradeoff and Sustainability
If inflation expectations are anchored, we are not in the “accelerationist world” in which an unemployment rate below the NAIRU would result in inflation spiraling higher and higher. As such, an unemployment rate one percentage point below the NAIRU would be sustainable, at least for some time, if the Committee accepted a 2¼% inflation rate for a limited duration.
A Symmetric Inflation Objective
An inflation objective that is symmetric conveys to the public that the FOMC will not overreact to a modest overshoot of inflation. The Committee emphasizes its commitment to 2% inflation in the longer run, but inflation will sometimes be above and sometimes be below, 2%. Indeed, a number of policymakers said they would be comfortable with a modest overshoot of 2%. This is consistent with Powell’s emphasis that the Committee should not overreact to such a modest overshoot.
Uncertainty about How Low the NAIRU Is
Powell has emphasized the uncertainty about the NAIRU, but always in the context of uncertainty about how low the NAIRU might be: to the point, in our view, that he entertains the possibility that it might be as low as 3½%. This uncertainty about how low the NAIRU might be is shared by many of his colleagues. For that reason, Powell has emphasized that we should let the data inform how low the NAIRU is. This is another reason why many on the Committee want to be cautious in responding aggressively
Modestly Leaning Against Inflation Above 2%
Another way of keeping inflation expectations anchored at 2% is to move the fund’s rate only modestly above the neutral rate (into a moderately restrictive position). By doing this, the FOMC would be leaning against the overshoot of the inflation rate. But this modest reaction would not be intended to force a quick return of inflation back down to 2%. After all, action is more powerful than talk!
Risk-Management and History-Dependent Policy
Which is the FOMC more worried about more, inflation modestly above the objective or a recession? Clearly, a recession. While Powell recently said he sees risks to inflation as balanced, he added that he was a little more worried about inflation being below 2% than above.
Recent history will affect FOMC decisions. The economy has experienced a long period during which inflation was below 2%. Policymakers are not deliberately engineering inflation above their objective. But they are unlikely to resist (and some would even applaud) an inflation rate modestly above 2%. Not quite a price-level targeting, but more tolerant of inflation above 2% for a while. They are much more worried about the possibility of overly tight monetary policy precipitating a recession. Given that the previous recession was so damaging and the challenge of providing sufficient stimulus at the effective lower bound, the Committee is likely to prioritize keeping the expansion going a little longer.
Historical regularities nevertheless do point to the recession probability rising in 2019 and 2020. Corroborating factors include a likely inversion of the yield curve, the fund’s rate rising above its neutral level, and an unemployment rate well below the NAIRU. Indeed, the Committee sees its own actions as creating recession risk. This will create angst within the Committee and reinforce the caution about raising rates after reaching neutral.
Our forecast also shows what appears to be a very favorable outcome in 2020. We show the unemployment rate stabilizing at 3½% as growth slows to trend in 2020 and inflation is on a very gradual rising trend (2¼% in 2020). But there is a hint of troubles ahead. Growth is on a steadily declining trajectory at this point, with fiscal stimulus behind us and the economy still adjusting to tighter monetary policy.