Chair Yellen gave a wide-ranging and comprehensive discussion of “inflation uncertainty and monetary policy.” The bottom line is that while a gradual path of rate hikes remains appropriate, the FOMC must be alert to a variety of possibilities that could imply that the recent slowdown in core inflation will be more persistent, and warrant easier monetary policy than now projected. These issues include lingering questions about slack in the labor market, some anxiety about eroding inflation expectations, and uncertainty about inflation dynamics. However, the questions Yellen is wrestling with won’t be settled by the December FOMC meeting, when the FOMC will have just a couple more months of data in hand, so we see this speech as consistent with our (close) call that the FOMC will raise rates in December. Yellen noted that there are, of course, risks of going too slowly. But while the FOMC may say that the risks to the inflation outlook are balanced, Yellen’s remarks suggest she might think otherwise. Still, for now, keep a steady hand, given that inflation is projected to reach 2% next year, but be alert to the need to adjust the forecast and monetary policy in response to data surprises that are persistent, most importantly continued unexpectedly low inflation.
Slack and the Unemployment Rate
While there is still some concern that there is more slack in the labor market than indicated by the U-3 unemployment rate, she is ultimately satisfied with looking at that measure:
On balance, the unemployment rate probably is correct in signaling that overall labor market conditions have returned to pre-crisis levels. But that return does not necessarily demonstrate that the economy is now at maximum employment because, due to demographic and other structural changes, the unemployment rate that is sustainable today may be lower than the rate that was sustainable in the past.
So this is less a story about what the appropriate measure of slack is than it is about uncertainty around the NAIRU. Both the unemployment rate and estimates of the NAIRU have been falling, and the NAIRU could continue to decline.
Yellen noted how important stable longer-term inflation expectations are to the monetary policy outlook:
The FOMC’s outlook depends importantly on the view that longer-run inflation expectations have been stable for many years at a level consistent with PCE price inflation that will average around 2 percent in the longer run. Provided this stability continues, standard models suggest that actual inflation should stabilize at about 2 percent over the next two or three years in an environment of roughly full employment, absent any future shocks.
Yellen acknowledged that “there is a risk that inflation expectations may not be as well anchored as they appear and perhaps are not consistent with our 2 percent goal.” As Brainard did recently, she discussed what
various indicators suggest about the stability of longer-term inflation expectations, admitting that measures surveys of consumers and market-based measures have fallen. That’s about as much anxiety as anyone else on the FOMC has voiced about inflation expectations. Wait and see, but be alert. Combine that with persistently lower-than-expected inflation, and that’s a dangerous mix.
Another risk is that our framework for understanding inflation dynamics could be misspecified in some fundamental way, perhaps because our econometric models overlook some factor that will restrain inflation in coming years despite solid labor market conditions…The growing importance of online shopping, by increasing the competitiveness of the U.S. retail sector, may have reduced price margins and restrained the ability of firms to raise prices in response to rising demand.
She notes that, if this downward pressure on inflation is persistent, then the NAIRU might be lower, warranting more-accommodative monetary policy than otherwise—a point we have previously made.
Upside Inflation Risks
Although the evidence is weak that inflation responds in a nonlinear manner to resource utilization, this risk is one that we cannot entirely dismiss.
She did provide some balance in her remarks by mentioning upside risks to inflation—but not much. Evidence is weak, but cannot be “entirely” dismissed. This speech was overwhelmingly about downside risks.
No attempt to be balanced about the risks to the FOMC’s inflation projections. The FOMC may say the risks are balanced, but Yellen’s characterization suggests otherwise. Risk management time yet? So, in the end, the FOMC must be alert to the possibility that policy will have to be easier than now projected. But for now, stick to the plan with a steady hand. So, gradual path to neutral, with a risk bias to a path more gradual than that which the FOMC currently expects.
Headed to Neutral, but Where Is It?
To make the policy decision even more challenging, while the FOMC has an estimate of what the neutral rate is today, there is great uncertainty around where it will be in the medium term. The FOMC believes, based on Yellen’s past remarks and participants’ rate projections, that the neutral rate will rise from about 2% in nominal terms today to 2¾% over the medium term. But again, they have to keep reassessing and revising their estimates and, therefore, the appropriate pace of rate hikes.
In response to an audience question about what would make the FOMC change the anticipated rate path, she pointed out that the inflation data are “very noisy month to month”: “hopefully this isn’t too much in the weeds—but there is residual seasonality in inflation and inflation data, which will tend to result in lower inflation readings” in the second half. So, while the FOMC will be evaluating incoming data “very carefully,” there is “no easy read.” She also repeated that the 2 percent objective is “not a ceiling” and it “wouldn’t be a tragedy” to witness an inflation overshoot. As such, she noted that a “gradual” pace is still an expectation that is “reasonable,” though “subject to a great deal of uncertainty.” Last, she pushed back against a suggestion to raise the inflation target, noting that policymakers must “consider not only the benefits, but also the costs, of a higher level of inflation.”
Steady as she goes, for now. Their forecast says maintain a steady, though gradual, pace of rate hikes as inflation heads to and stabilizes at 2% in 2018 through 2020. The recent data raises some concern about even the gradual pace projected by participants. Will the data change first (higher core inflation readings) or will the forecast (downward revision to inflation projections)? That’s the question with respect to the pace of rate hikes. At this point, participants believe the data will change first.
A December rate hike is still likely, but not a slam dunk. And these issues will become more salient as we head into 2018, especially into Q2, when the earlier price-level shock drops out of the window for the 12- month measure.