No, the FOMC is not preparing to ease in the sense of building a consensus and preparing the markets for an easing (as opposed to a hike) as the next move, though the markets are already pricing in easing ahead. What I mean here is that the FOMC should be preparing to ease by discussing and agreeing on not when but how to do so. Relevant issues include how the zero nominal bound should affect rates policy, how to coordinate balance sheet and rates policies, what the strategy will be at the zero nominal bounds, and what communication there will be along the way. Here we discuss what preparation we believe is called for and our guess at how the Committee will adjust its strategy and communication.
The Committee apparently will pause in March. And a June hike is up in the air at this point, acutely data-dependent now that the fund’s rate is at the edge of neutral. We expect a rate hike in June, but it’s a close call whether that hike is the last of this cycle. The data speak to past strength in growth and the labor market. But the problem with data dependency is that it is backward-looking. While the Committee celebrates the backward-looking strength, it has forward-looking angst. Participants’ macro projections, for example, point to a sharp slowing in growth, indeed to a below-trend rate, accompanied by a rising unemployment rate later in the forecast—under “appropriate” policy, interestingly. And, in addition, the balance of risks now appears to be weighted to the downside. That calls for a risk-management, wait-and-see policy over the next six months. There’s uncertainty about the effects of fading fiscal stimulus, past rate hikes, and trade tensions. Growth appears to be slowing globally, with heightened angst especially about a slowdown in China. There’s also uncertainty about Brexit and the effect of the partial government shutdown on growth in the near term and on sentiment. So, yes, it’s time to prepare.
This Time is Different
You might ask why the FOMC needs to prepare before easing. After all, the Committee surely knows how to ease! But, as we have emphasized: This time is different. Let’s count the ways.
1. The real fund’s rate and r-star are much lower than at other times when the Committee first eased, and there is an uncomfortably high probability the Committee will be constrained by the effective lower bound (ELB) in the next recession. That’s why many market participants appear to be pricing in a near-zero funds rate over several years. More generally, a lower r-star implies that monetary policy will more frequently be constrained by the zero bound than in the past.
2. The Phillips curve has become even flatter, and today the relationship between inflation and economic activity hardly seems visible. Don’t worry, I’m still a Phillips curve kind of guy, but I have to admit that the Phillips curve is a shadow of its former self. Witness the unemployment rate ½ pp below the NAIRU and projected to fall to about 1 pp below the NAIRU—all with virtually no effect on inflation, at least as projected by FOMC participants. So, inflation is muted and expected to remain so. As a result, too-high inflation appears to be of little concern for the FOMC’s near-term strategy.
3. I believe we are back to (or close to being back to) the stable trade-off world of the 1960s—a possibility that’s not talked about much. If the inflation rate were to move modestly above 2%, inflation expectations would likely rise to and become anchored for some time at 2%, assuming the FOMC communicates appropriately. If inflation expectations are fixed, we are back to the stable trade off world, at least for some time.
4. There is greater recognition of how policy has to adapt to the uncertainty about the NAIRU and r star. Not that we didn’t appreciate this uncertainty, but it didn’t appear as relevant for a policy as it appears it will be this time. Both longer-term trends and the most recent recession and recovery have implications for these variables. We are still learning about the NAIRU and r*, which are central to setting policy, and this is contributing to caution with respect to further rate hikes.
5. There are two instruments that have to be coordinated.
6. When the FOMC eases, the balance sheet will be dramatically larger than in other episodes. The Initial Conditions Will Be Different
The initial conditions are likely to be dramatically different when the FOMC first eases, relative to earlier experiences, and this will create a challenge for policy and policy communication.
▪ I expect the FOMC will ease before it’s clear that the unemployment rate is rising significantly, and while it is still below the estimate of the NAIRU (currently 4.4%). Of course, you might say that this is just what the doctor ordered: a gradual and welcome slowdown in growth to a below-trend rate that gently lifts the unemployment rate to the NAIRU without a recession. But an important and cautionary historical regularity is that once the unemployment rate has risen just a few tenths, there is no turning back: The economy is either in a recession or headed for one.
▪ Inflation is muted and expected to remain that way. Indeed, many on the Committee appear to believe that inflation is more likely to be below 2% than at 2% on a sustainable basis. Certainly, no runaway inflation. The Committee typically hikes rates to lean against the risk of higher inflation. But there doesn’t seem to be such an imperative today to go further.
The Balanced Approach Strategy: Priorities and History Dependence
The balanced approach strategy, as laid out in the statement on strategy, is about priorities. Today, given muted inflation, a projected slowing in growth, and downside risks, the priority is clearly on extending the recovery, with concern about inflation playing a lesser role in shaping near-term policy.
And priorities are often history-dependent, and I expect that is the case today. After all, inflation has been persistently below 2% for a number of years, so a modest overshoot should perhaps be welcomed, or at least not resisted. The memory of the Great Recession puts a priority on extending the expansion.
Rate Strategy, the New Normal, and the ELB
Now onto preparation, strategy, and communication. First, rate strategy. Rate strategy should be different than in previous easing cycles, though the FOMC easing in the last recession embodied some of the principles that should guide rate policy in the next one. To sum it up in two words: preemptive and aggressive. By preemptive, I mean more preemptive than in the past, beginning perhaps as early as when there emerges a serious question about whether the next move should be up or down! Better to have to take a rate cut back than to risk the consequences of not moving in a very timely, preemptive manner. Frankly, there is little risk of going in the wrong direction—easing—if later data tell us it was premature. And if you get to the point when there is a question of whether the next move might be up or down, perhaps the message should be, at least don’t hike rates any further! By the way, given the macro projections, which have the unemployment rate rising in 2021, I hope the Committee really won’t even consider raising rates in 2020.
With respect to being aggressive with rate cuts, I mean along the lines of the cuts during the Great Recession, from 5¼% to near zero in 15 months. But the fund’s rate will likely be close to 2½% at the time of the next recession, rather than above 5%, as it was before the last recession, leaving even less (and insufficient) room to ease. So, the rule here, I believe, should be to substitute speed in getting to the ELB for distance to the ELB. Communication will be key. The FOMC will have to explain that the speed of its easing is about risk management and not an indication that it is forecasting a serious recession.
Announce the FOMC Will Remain in the Current Operating Framework
As we’ve said before, I cannot think of a good reason why the FOMC has not announced what its operating framework will be going forward: remaining in the current regime of super-abundant reserves or returning to the prior regime of scarce reserves. I thought this decision would be a no-brainer. In any case, it doesn’t make much sense to talk about any adjustment to normalization principles, as the Committee should before this decision is made and announced. What’s strange in this respect is that we all know the Committee will remain in the current operating framework! If we know, then presumably the FOMC knows, too!
Changes to the Normalization Principles and Coordination of the Two Instruments
I agreed with the normalization principles, especially as amended in June 2017. But there are three changes that might be warranted today.
First, the guidance about the size of the normalized balance sheet. Here is the current language:
“The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively.”
This was fine when the Committee was raising rates and beginning to shrink the balance sheet passively. The Committee doesn’t need a $4.5-trillion balance sheet to remain in the current framework. But this language focuses on the decline in the balance sheet, even though we know the normalized balance sheet will still end up being very large. Indeed, the Committee could say that size could be near, perhaps a bit higher than $3.5 trillion, relative to its level today (just above $4 trillion). Perhaps the principles should be restated as:
The Committee seeks to operate with a level of reserves high enough to allow the Committee to maintain the fund’s rate well within a narrow range in the current operating framework.
A second adjustment to the normalization principles that could be warranted at this time would be to say that the FOMC anticipates that it will sell its residual holdings of MBS in the portfolio once these holdings have shrunk to a sufficiently small size. Even when the balance sheet shrinks via runoff to what the Committee sees as its new normalized size, there will still be a lot of MBS left on the balance sheet. So the Committee will have to be buying Treasuries as MBS continues to roll off to maintain a balance sheet of a normalized size. But it will take a very long time for all of the remaining MBS to run off organically. Not so important, but I expect the Committee will be more comfortable at some point with selling the residual amount. That will help them get to what we expect is the objective, an all-Treasury balance sheet. Really no problem in doing so. Just a matter of communication.
A third adjustment that is warranted today is to move away from the idea that the shrinking of the balance sheet is on autopilot, the message that markets seem to have taken from the FOMC’s principles. When the Fed was raising rates, it made sense to have one instrument active, the other passive. But it does not make sense for the Committee to ease using rates while it continues to tighten via the shrinking of the balance sheet. But the question perhaps goes deeper. If the FOMC does not raise rates in June, we think the window for further tightening will have nearly closed, given the evidence that will already be in hand about the degree of slowing underway and the risk of recession, as a result, becoming uncomfortably high. The Committee seems not to have reached a consensus on and is struggling with its communication about the extent to
which the shrinking of the balance sheet policy is still on autopilot versus data (and forecast) dependent now, just like rates. An announcement wouldn’t have to necessarily signal an imminent change in runoff policy. But it would be good forward-looking guidance.
Policy at the Zero Bound
The Committee must also reach an agreement on any adjustment to its strategy and communication. The Committee has scheduled a conference in June to hear ideas from academics, financial market participants, and other groups. This will certainly be interesting. The Committee expects to reach an agreement on any adjustment and announce them in 2020, presumably when they consider any changes to the statement on longer-run goals and strategy at the January 2020 meeting. This schedule appears too late. Hopefully, the Committee will have a good idea of what it wants to do already, and the conference and outreach will be more of a public relations effort!
We take this reassessment of strategy and communication to be firmly centered on making the policy more effective at the zero bound. As I have said before, I do not expect price level targeting or nominal income targeting to be the direction in which the Committee goes. Too difficult to communicate, too demanding, and likely not credible. An increase in the inflation objective is, understandably, already off the table, and I expect there will not be a consensus to move to negative rates. I expect QE will be on the table, but not the first option, and perhaps not implemented in these circumstances. This partly reflects a rethinking of its effectiveness, and especially diminishing returns and the absence of what some have called policy space, the willingness of the Committee to expand the balance sheet much beyond the 3½-to-$4-trillion balance sheet likely at the time.
While we do not expect price level targeting, the idea of aggressive forward guidance and history-dependent policy is compelling, at least at the zero bound. We expect relatively quick and aggressive threshold-based guidance to be the direction the FOMC will decide to pursue.
In this respect, I’ll distinguish, as has Williams, “average inflation targeting” from “price-level targeting.” The latter is strictly a commitment to achieve an average inflation rate equal to the 2% objective. I have called the former a “poor man’s price level targeting.” Average inflation targeting has the same spirit as price-level targeting but without the strict commitment of price-level targeting. I see it as a sharper form of asymmetric inflation objective: Not only recognizing that inflation will sometimes be above and sometimes below 2% and that the FOMC should not overreact, but that the Committee will explicitly seek to raise inflation above 2% (but below 2½%) following a persistent period of well-below-2% inflation. This is a very aggressive form of lower-for-longer guidance. In any case, the Committee is likely to get even more help from markets than in the last experience, as market participants will not have to be prodded into believing that rates really will be near zero for quite some time.
Prepare to Ease
The message here is that the Committee’s preparation for easing is more difficult and challenging than before, and a formal effort needs to be underway sooner rather than later. These are just a few ideas. We hope that the Fed, with its staff and nineteen FOMC participants around the table, will come up with ideas that are at least as promising.