In the last two expansions, the unemployment rate fell below the NAIRU, by ½ percentage point in one case and by 1 percentage point in the other. Inflation in each case moved to near 2% or modestly above for a few years. The FOMC raised the fund’s rate beyond the estimated neutral level in each case, by 100 basis points and 200 basis points, respectively. In each case, a recession quickly followed. Today, the unemployment rate (4.1%) is already ½ percentage point below participants’ median estimate of the NAIRU (4.6%), and we expect it will undershoot the NAIRU by a full percentage point and stabilize there through 2020, while inflation moves to slightly above 2%. Notwithstanding this, the median projection of FOMC participants has the fund’s rate moving just to the median estimate of the neutral rate by the end of 2019, with a marginal overshoot in 2020. Apparently, the FOMC believes that this time is different! And it may very well be. Here we consider changes in economic regularities and monetary policy strategy that may account for differences in how the Committee expects to conduct policy.
The unemployment rate seems destined to fall below 4% relatively soon, given that it is already 4.1%, it has been declining faster than expected, the economy is growing at an above-trend rate, and growth momentum seems to be building. We expect that the unemployment rate will fall to 3.6% by 2020, nearly a full percentage point below participants’ median estimate of the NAIRU.
Given the slowdown in core PCE inflation from 1.9% (12-month basis) in February to 1.3% in September, upside inflation risk appears muted in the near term. But if much of the slowdown proves transitory and inflation rises to the edge of 2% next year and 2% in the following two years, consistent with participants’ projections, the Committee could find itself at a 2% inflation rate with an unemployment rate a full percentage point below the NAIRU by 2019, if not earlier.
Don’t Fall “Behind the Curve”
That scenario looks like an example of the FOMC getting “behind the curve,” that is, not beginning to raise rates soon enough and/or quickly enough to avoid a substantial undershoot of the NAIRU, sometimes referred to by participants as a “hot” labor market. That, in turn, raises the risk of a material overshoot of the inflation objective, which would call for a quicker pace of rate hikes than otherwise and/or an increase in the fund’s rate above its estimated neutral level. That is often a prelude to recession. Note that falling behind the curve is not about the incoming inflation data revealing an overshoot of the inflation objective. Rather, it is about a
heightened risk of overshooting when the unemployment rate falls below the estimated NAIRU. Lessons from Recent Expansions
We focus on four lessons from the two previous two expansions, 1991-2001 and 2001-2007. In each expansion:
1. The unemployment rate fell below the estimated NAIRU.
2. Inflation was rising toward 2%, but either did not subsequently reach 2% or only modestly and temporarily exceeded 2%.
3. The funds rate moved above the estimated neutral funds rate.
4. A recession quickly followed.
Undershooting (the NAIRU)
In Figure 1 we plot the unemployment gap, the unemployment rate minus the NAIRU.1If the unemployment rate undershoots the NAIRU, the gap is negative. In the 1991-2001 expansion, the unemployment rate fell a full percentage point below the estimated NAIRU, and in the 2001-2007 expansion, the unemployment rate fell ½ percentage point below the estimated NAIRU. We view this as a cyclical regularity. The unemployment rate has already fallen below the estimated NAIRU in this expansion, by ½ percentage point.
Overshooting (the Inflation “Objective”)
In Figure 2 we plot the inflation gap, the difference between prevailing core inflation (four-quarter core PCE inflation rate), and the 2% objective.2In the 1991-2001 expansion, the inflation gap began to narrow in 1998 and almost fully closed by the end of the expansion. In the 2002-2007 expansion, the inflation rate moved above 2%, but never higher than 2.4%, corresponding to an inflation gap of 0.4 percentage points. Note that the inflation rate today is well below 2%, but projected by FOMC participants to be nearly at the objective in 2018 and at 2% in 2019 and 2020.
1 Here the estimated NAIRU is taken from Greenbooks until 2012. Beginning in 2012, we use participants’ median estimate of the unemployment rate in the longer run. For the forecast period, we show participants’ median projected path of the unemployment rate. 2 We assume the inflation objective is 2%, even though the FOMC did not announce an official numerical inflation objective until 2012. For the forecast period, we show participants’ median projected path of core PCE inflation from September 2017.
Overshooting the Neutral Rate
In each of the last two expansions, with the unemployment rate falling below the NAIRU and inflation heading back to and threatening to go above 2%, the FOMC raised the real fund’s rate above its estimated neutral level.3 The real fund’s rate moved 200 basis points above the neutral level in the first expansion and 100 basis points above in the second.
Recessions Typically Follow An Undershooting of the NAIRU
There are typically several drivers of recessions, but frequently at the top of the list is monetary policy getting behind the curve, specifically an overshoot of the neutral fund’s rate following an undershoot of the NAIRU. Figure 3 is shaded for recessions, so you can see that this was the case in the last two recessions. We naturally wonder whether this pattern will repeat itself in the current expansion.
Why Might This Time Be Different?
While the unemployment rate is already below the NAIRU, as in the last two expansions—and projected to fall further below the NAIRU—and inflation is expected to move toward 2%, the fund’s rate is nevertheless projected by the FOMC to move only to its neutral level in 2019.4 That’s different from the much more aggressive overshooting of the neutral fund’s rate in response to the undershooting of the NAIRU in the previous two expansions.5 several considerations may help to explain the seeming inconsistency between the FOMC’s median projections and previous experience.
1. Reaping the Benefits of a Hot Labor Market
One feature of participants’ macro projections, based on their individual assessments of appropriate policy, has been that the unemployment rate falls below, indeed stabilizes below, the median estimate of the NAIRU.6
3 For the real neutral rate, we assume it was 2½%, the assumption I was making, with staff input, while at the Board, until participants began reporting estimates of the fund’s rate in the longer run. For the forecast period, the fund’s rate gap is calculated using FOMC participants’ median projections.
4 We focus on 2019 because in 2020 participants’ median fund’s rate projection does move above the median longer-run level. But the overshoot in 2020 is just ⅛ percentage point, very slight compared to the much more aggressive overshoot of the neutral rate in the last two expansions.
5 The neutral rate is estimated to have fallen during the post-Great Recession period. We account for this by focusing on the degree of overshoot or undershoot of the fund’s rate, measured by the gap between the fund’s rate and its neutral level. See Chair Janet L. Yellen, “Normalizing Monetary Policy: Prospects and Perspectives,” March 27, 2015, at “The New Normal Monetary Policy,” a research conference sponsored by the Federal Reserve Bank of San Francisco, San Francisco, California.
6 While the undershoots of the estimated NAIRU have generally been modest—less than ½ percentage point—the prevailing unemployment rate today is already five-tenths below the estimate of the NAIRU and, in our forecast, that gap widens to a full percentage point over the medium term. And that looks like getting behind the curve!
An undershoot of the unemployment rate, if material, is sometimes referred to as a hot labor market, which is essentially the same as “falling behind the curve”! Participants have discussed the potential long-term benefits of doing so modestly and temporarily. Yellen, as well as others, have offered two reasons why such a strategy may be appropriate. An undershooting of the NAIRU would likely move inflation more quickly and assuredly to 2%. This seems more important today because core inflation has been below the 2% objective for the last five years. In addition, some participants believe that a hot labor market would yield tangible long
run benefits, for example, raising the participation rate and encouraging workers who had dropped out to return to the labor market.
2. Flatter Phillips Curve
The Phillips curve is flatter, or perhaps more precisely, the flatness of the Phillips curve is better appreciated as a consideration in the monetary policy response to an undershooting of the NAIRU. A flatter Phillips curve means the tradeoff between inflation and unemployment is more favorable; that is, the perceived cost of undershooting the NAIRU has become much smaller. This may make the cost-benefit analysis tilt toward a temporary and moderate undershoot of the NAIRU.
3. More-Stable Tradeoff Between Unemployment and Inflation
Previously we thought and taught that there was only a short-term, but not a long-term, tradeoff—the so-called accelerationist or vertical Phillips curve. If that were the case, and the unemployment rate moved persistently below the NAIRU, inflation would rise further and further as long as the unemployment rate remained below the NAIRU. That’s because, in the accelerationist model, inflation expectations follow inflation, resulting in a cycle of progressively higher inflation and higher inflation expectations until the unemployment rate returns to the NAIRU. But today, inflation expectations appear to be well anchored—or sufficiently anchored—so inflation expectations don’t follow inflation, and are, in effect, fixed in the Phillips curve. In this case, the undershoot of the NAIRU may be sustainable over the medium term as long as inflation expectations remain stable. However, today participants think are concerned that some measures of long-term inflation expectations appear a bit wobbly. This, in turn, leads to concern that inflation expectations may be eroding, that is, moving in the direction of the prevailing below-2% inflation rate.
4. Uncertainty about the NAIRU
While there is always plenty of uncertainty about the level of the NAIRU—after all, it’s an unobserved variable that has to be estimated rather than measured—today that uncertainty seems to be about how low it is. Indeed, the estimated NAIRU has steadily declined and, all along the way, many policymakers have thought the NAIRU might be still lower. “Is there still running room?” is a question asked again and again. Maybe the only way to be sure is to raise the fund’s rate more gradually than otherwise until inflation rises enough to convince policymakers that the unemployment rate really is below the NAIRU. In addition, given the uncertainty about the NAIRU, it might be better to think of it as a range around a point estimate, rather than as a point. In this case, policymakers again may prefer to adjust policy more cautiously when within a narrow range around the point estimate and become more aggressive when there is more confidence that the unemployment rate is above or below the point estimate.7 That confidence will likely depend on inflation moving up as the unemployment rate falls, consistent with a Phillips curve framework.
5. The Symmetric Inflation Objective
Policy strategy may be different if the inflation objective is interpreted as symmetric, as opposed to a ceiling. The word “symmetric” entered the policy narrative when the FOMC amended its Statement on Longer-Run Goals and Monetary Policy Strategy in 2016. Just a clarification, we are told. But we believe words matter! Technically, asymmetric objective means that monetary policy should respond with the same intensity to overshoots and undershoots of the inflation objective. But a corollary may be that policymakers should be
more tolerant of modest and temporary overshoots of the inflation objective during expansions, as these will offset the inevitable undershoots of the inflation objective during downturns. The advantage, in this case, is that it is more likely that inflation will average 2% over the cycle.
6. A Lower Neutral Funds Rate
In a world with a low r-star, there is a greater likelihood of the FOMC being constrained by the effective lower bound (ELB) when the economy is hit with an adverse shock. As a result, policymakers may not be able to lower the fund’s rate as much as might be necessary to offset the shock. In this case, there is a benefit to overshooting the inflation objective at the peak of the cycle, especially if that leads to a higher funds rate than otherwise: It builds in more room for the funds rate to fall without hitting the zero bound and more of a buffer against deflation!
7. Objectives Are Not Complementary
The Statement on Longer-run Goals and Monetary Policy Strategy says that the FOMC should follow a “balanced approach” strategy under certain circumstances—specifically, if its objectives are not complementary.8In this case, a move in the fund’s rate in one direction will push one variable toward its mandate-consistent level and the other away.9 Today, a rise in rates would push the unemployment rate toward the NAIRU and would move inflation further away from its objective. Hence the objectives appear not to be complementary. The policy question today is whether to tighten more slowly, to facilitate inflation reaching 2%, or more quickly, to limit the decline in the unemployment rate.
Most, if not all, of these considerations, point to a less-aggressive policy response to an undershooting of the NAIRU in this expansion, compared to the last two. Still, any Taylor-like policy rule calls for an overshooting of r-star when the unemployment rate is below the NAIRU and inflation is at the FOMC’s objective. No getting around this. Well, maybe there is. In a follow-up commentary, we will search for a policy rule consistent with both participants’ median macro projections and median rate projections.