The next important decision of the FOMC is whether, why, when, and how long to pause. Based on the median dots, participants expect a pause sometime in 2019. We assume the Committee skips a rate hike in September 2019.
Go Directly to Neutral: But Where is Neutral?
We see a three-step process for monetary policy:
1. Go to neutral.
2. Pause while being informed by the data.
3. Make a decision about whether to go further.
We have said the FOMC would go directly to neutral. Participants’ median estimate of the neutral rate is 2.9%, and nine out of fourteen longer-run dots, nearly two-thirds, are concentrated in the narrow range of 2.75%-3%. That level would be reached with a 25-basis-point hike at every other meeting through June 2019.
The logic seems clear enough. The economy is growing at a rate well above its estimated trend and is expected to continue to do so at least through 2019. The economy growing above the trend is confirmed by the steady decline in the unemployment rate. Inflation is already at 2%, and the unemployment rate is well below the NAIRU. How could the Committee question that it is no longer appropriate to remain accommodative, that policy should be at least neutral?
Optimal Policy Under Uncertainty
Powell has raised a serious question about such a well-defined strategy. He emphasizes the uncertainty about estimates of the unobserved neutral rate, which have wide confidence bands. So how should they conduct policy in the face of such uncertainty? Actually, it’s even worse. The strongest case for removing accommodation is how low the unemployment rate is. But we judge that relative to the NAIRU. And where’s the NAIRU? Sure looks like it may be below 4½%!
Let the Data Speak
So how will you know what the neutral funds rate and the NAIRU are? Let the data speak.
I understand that. But that’s a backward-looking policy and we were taught that good monetary policy is forward-looking, forecast-based. To be sure, policy decisions always have to take both the data and the forecast into account. And this Committee has been forecast-based in recent years–though of course with several “show me the inflation” dissidents! By the time you see an unacceptably high inflation rate, it will be too late. With the lags in monetary policy, without very aggressive action, you have made a serious policy error.
Still, as Powell says, invoking the Brainard principle, there is literature that says you should be cautious under uncertainty. But that is exactly what the Committee has been by maintaining a gradual pace of hikes and remaining accommodative even as inflation was approaching 2% and the unemployment rate was falling a bit below the NAIRU. But what now? Pause before you get to your best estimate of the neutral fund’s rate? Of course not.
The Committee, while appreciating the uncertainty of any estimate of neutral, believes it is important at this point to remove any remaining accommodation and is prepared to do that based on participants’ median estimate of the neutral rate. This is easier, of course, as participants’ estimates are concentrated between 2.75% and 3%. Following Powell’s language, get into the range, or neighborhood, of neutral. And that has a pause after the June meeting written all over it! And that is even though, given the wide confidence interval around the estimate, the actual neutral rate may well lie outside that range.
Pause for How Long?
That may be a more vexing question than why and when. Until the fund’s rate reaches neutral, participants’ median estimate rules, imprecise as it is. Once at what is thought to be neutral, the question becomes whether to go restrictive and the Powell doctrine of “Let the data speak” becomes more compelling.
And there is clearly angst among participants about what to do once the Committee has raised the fund’s rate into the range of neutral. Let’s see what the data and the forecast are likely to be, based on participants’ median macro projections in June. Inflation will be 2% and will have been there for about a year. Participants’ median forecast is that inflation will essentially remain there through the end of 2020. That raises the question: Why go to a restrictive posture?
Historical Regularities Say: Stop Where You Are!
Yes, the Committee has to navigate between two things,
1. going too slow and facing unacceptable inflation and
2. going too fast and precipitating recession.
Today, historical regularities suggest that, if the Committee moves into a restrictive posture (even only modestly), as the median FOMC dots envision, a recession is likely. First, a funds rate above the estimate of its neutral level has been a reliable predictor of recession (link). Second, the yield curve is likely to be inverted. Notwithstanding the Fed staff note, the three-month to ten-year yield spread has been a reliable indicator of recession.1 The yield curve will quite possibly be inverted, not only because the FOMC will have raised rates another 100 basis points, but also because the ten-year yield may face downward pressure as markets build in a higher probability that the next move will be to ease. And the unemployment rate will be well below the estimated NAIRU. That never ends well.
But Powell has said that historical regularities may not hold this time.
Risk Management: The Case for Stopping at Neutral
Risk management considerations may be the key in deciding how long to pause and whether to resume rate hikes. Consider the two opposing risks and the balance between the two: higher-than-acceptable inflation and an uncomfortably high probability of recession.
There are two elements in risk management here. How costly are the possible policy errors in each direction? Still, this looks easy. It’s really hard to get unacceptably high inflation with such a flat Phillips curve and
1 Engstrom, Eric, and Steve Sharpe (2018). “(Don’t Fear) The Yield Curve,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, June 28, 2018, https://doi.org/10.17016/2380-7172.2212.
inflation expectations that are unlikely to rise above 2%, at least for some time, with effective communication about the commitment to a symmetric 2% objectives and after inflation have been below the objective for some time. But the cost of precipitating a recession is very high, economically, socially, and perhaps politically. After the slow recovery from the Great Recession, now finally back to a strong economy, with the unemployment rate low and inflation near its objective, I see the Committee as perceiving the risks as sharply unbalanced: Protect against a recession and tolerate inflation modestly above 2%, albeit with some risk that it will be rising from there. And, after all, there will be a good case that the next move will be to ease, perhaps even a return toward the zero nominal bounds.
Risk Management: The Case for Moving Modestly Above Neutral
This time may be different, but there are precautions to take to better balance the risks. One such precaution is moving very modestly above the estimated neutral rate. That way the Committee is walking the walk, not just talking the talk. It is leaning against a potential overshoot of the inflation objective, but very cautiously, hopefully modestly enough to keep growth positive and reap the benefits of a low unemployment rate a little longer.