Wrestling With the Inflation-Labor Market Disconnect

The FOMC will, of course, raise the funds rate target range by ¼ pp to 1¼-1½% at this meeting. The  question is why! 

▪ To be sure, there remains a disconnect between the unexpected and not-well-understood slowing in core inflation and the faster-than-expected decline in the unemployment rate, which is already ½ percentage point below the NAIRU. 

▪ While almost all participants see the slowing in inflation as mysterious, most nevertheless expect it to be temporary, while the decline in the unemployment rate is expected to be more persistent and ongoing.  Hence, the decision to hike in December. 

While there is obviously no mystery about the decision on Wednesday, the day will be filled with FOMC  communications that will inform our view of policy in 2018. 

▪ The statement will not provide any signal about March, except for an upgrade of the assessment of the labor market and a nuanced further upgrade of the assessment of recent inflation developments. ▪ The projections will do most of the talking, so pay attention to the upward revision in growth, especially for 2017, and the downward revision in the path of the unemployment rate. Watch especially the projection of core inflation for 2018, which will indicate whether the Committee continues to expect the slowdown in core inflation to be temporary. 

▪ The movement in the rate projections will also provide a summary of participants’ assessment of the implications of any forecast revisions for the path of monetary policy. We expect the median dots for  2018 will shift: fewer below three, more at four, a couple now at five. But the median will very likely remain at three hikes. 

We expect the FOMC will raise rates four times in 2018, in contrast with the September median dots (and,  we expect, the December median dots), reflecting forecast revisions. We also recently added a hike in 2020  in our forecast. 

▪ The revisions to our forecast include a ¼-percentage-point increase in growth in the second half of 2017,  bringing full-year growth to 2.6%; a slightly faster pace of wage growth (ECI for total private compensation); slightly higher core PCE inflation; and a lower path of the unemployment rate in the near term, reflecting the lower jumpoff. 

▪ With those changes, our forecast warranted four rate hikes in 2018. The faster pace of hikes in turn takes something off growth in 2019 and 2020. 

▪ That reduces downward pressure on the unemployment rate in our updated forecast, so that its path,  while lower initially, still reaches a low of 3.7%, in 2019, almost a full percentage point below the NAIRU. 

Outlook Context 

We expect the so-called “mystery” of the unexpected and sharp slowing in core inflation, even while with an unemployment rate declining well below the NAIRU, to be mostly resolved in 2018. We expect that the slowing in core inflation will prove mostly temporary, while the recent decline in the unemployment rate will be more persistent and ongoing, as is also expected by FOMC participants. We see greater momentum in growth going into 2018 than at the time of the last FOMC meeting and certainly more than was reflected in participants’ September macro and rate projections, contributing to a further decline in the unemployment rate to rate almost a full percentage point below the NAIRU. We expect wage inflation to continue its apparently nascent upturn. We continue to expect fiscal stimulus, which will boost growth modestly, with the effect on growth tempered by a faster pace of rate hikes. 

Growth Momentum Picking Up; Unemployment Rate Still Falling 

Even before fiscal stimulus, growth momentum appears to be building. Some of the added momentum may reflect improved business sentiment as the prospects for tax legislation have improved and the details have been clarified, as well as the business-friendly deregulation underway. In addition, financial conditions have continued to become more accommodative. The 3.3% rate of real GDP growth in Q3 was six-tenths higher than we anticipated in our forecast ahead of the BEA’s first print and the October/November FOMC meeting.  We expect a moderation in growth in the fourth quarter, but that is because of drag from inventories and net exports; we expect final private demand to actually pick up. We expect a 3% growth in the second half, bringing full-year growth to 2.6%, followed by near-2½% growth in 2018. 

Inflation: The Data versus the Forecast 

The sharp slowing in core inflation earlier this year is, to be sure, inconsistent with predictions from empirical  Phillips curves. On the other hand, participants’ projections are more in line with empirical Phillips curves, as is our forecast. So, who will you believe? 

Sometimes the incoming data is consistent with what is expected based on empirical regularities, in this case, empirical Phillips curve models. But this is not one of those times. The 12-month core PCE inflation rate had reached a recent high of 1.9% in January and had been 1.8% or 1.9% from August last year through  February, essentially at the 2% objective. The Phillips curve looked pretty good then! However, that rate fell to 1.3% and is now only 1.4%. It’s true that some of the declines owe to a price level shock in March, but the slowdown in core inflation is much more dramatic than can be accounted for by its lingering effect. It is,  in short, mysterious. 

The consensus for a December hike is based on participants’ forecasts of inflation, not the recent incoming data. Those forecasts are presumably based on the Phillips curve, and some are skeptical of Phillips-curve-based forecasts of inflation. Once again, there is a split between the data-focused “show me the inflation”  camp and the forecast-based camp on the FOMC. These considerations will hang over the Committee into  2018. 

Inflation and Labor Market Reconnect in 2018 

The Committee has been wrestling with the implications of the disconnect between inflation and the unemployment rate seen this year. In on our forecast, and, to a lesser degree, participants’ September projections, the inflation, and the unemployment rate gap will be reconnected in 2018, though perhaps not definitively until into Q2.

That’s a forecast, though, and only the incoming data will reveal the reconnection of inflation and the unemployment rate gap. Our forecast and participants’ September projections indicate that inflation will rise to the edge of 2% in 2018. That reconnects inflation and unemployment. Our forecast is now more in line with our empirical Phillips curve because, with a significant undershoot of the unemployment rate relative to the  NAIRU, inflation modestly overshoots the 2% objective. That overshooting is more consistent with our forecast because, although the Phillips curve is quite flat, we have the unemployment rate falling nearly a full percentage point below the NAIRU. We expect the December unemployment rate projections to decline two or three tenths, to below 4% in 2019. 

A Nascent Upturn in Wages? 

A number of participants have pinned their expectation/hope for a rebound in core inflation to an upturn in wage inflation, which in turn would be passed through to price inflation. That relationship is not evident in typical empirical Phillips curves but is nevertheless intuitively plausible. Others see an upturn in wage inflation as significant because it might indicate that slack is indeed eliminated, which may be relevant to those who think the Phillips curve may be nonlinear. In any case, the data is at least hinting that such an upturn may be beginning. For example, the ECI for total private compensation firmed in Q3, bringing the year-over-year rate up to 2.6% after it had been stuck around 2¼%. We adjusted up our forecast a tenth each year over the next few years so that ECI increases 3.2% in 2020. 

FOMC Call 

Despite the unexpected, material, and not well understood slowing in core inflation, there is a strong consensus to raise the fund’s rate target range by 25 basis points in December. This reflects the expectation that the slowing in core inflation is likely to prove temporary, while the recent decline in the unemployment rate will be persistent and, indeed, likely to be followed by further declines. The case for a December hike is further supported by revisions to participants’ projections based on the recent data, a concern that the  Committee may be getting behind the curve, financial conditions that have become no less accommodative despite funds rate increases and projected further increases, and concerns about financial stability risks. 

December: In the Bag 

The FOMC will raise the fund’s rate target from 1%-1¼% to 1¼%-1½%, bringing the funds rate about halfway to the estimated neutral level. The question is why especially given the poorly understood and quite sharp slowing in core inflation by ½ percentage point since February. While the slowing in the core is mysterious,  the consensus is that it will prove temporary, while the ongoing decline in the unemployment rate to further and further below the NAIRU appears more persistent. This concern is building given recent changes in the outlook, which we expect to be reflected in the revisions in FOMC participants’ December projections. A  wait-and-see posture until next year seems imprudent. Go in December and focus on the incoming data between the December and March meetings to get a better handle on whether the incoming data support the notion that the slowdown is temporary. 

Behind the Curve? 

A fear of falling behind the curve, and evidence that this might already be underway, always drive policymakers during tightening cycles. It’s already there and even mentioned in explaining the decision to start rate hikes. And it is building and will heighten if the slowdown in core proves temporary while the unemployment rate continues to decline to further below the NAIRU. We can expect to hear this phrase in talks by participants before and after each rate hike.

Four Hikes in 2018 

There is more momentum in growth than anticipated, and fiscal stimulus is likely to add to that. The unemployment rate has declined much faster than expected this year, is already ½ percentage point below the NAIRU, and will likely decline even further next year, a few tenths in our forecast. We also marked up our forecast for wage inflation slightly on the strength in the most recent ECI report. Finally, the recent core inflation data have been somewhat firmer and we expect the incoming data to gradually increase confidence that the slowdown in core inflation was (at least mostly) temporary. Given this outlook, we expect concern within the Committee about falling behind the curve to build next year, so we assumed a faster pace of rate hikes in our recently updated forecast. We now assume four hikes in 2018. 

Overshooting Neutral 

There appears to be an emerging disconnect between participants’ macro projections and rate projections. In their September projections, in 2019 inflation is 2%, the unemployment rate is half a percentage point below the NAIRU, and yet the FOMC projects no meaningful overshoot of the fund’s rate relative to its longer-run neutral level. In the last two expansions, such a configuration of the unemployment rate and inflation led the  Committee to raise the fund’s rate well above neutral, 100 basis points in one case and 200 basis points in the other. Such an overshoot is consistent with the Taylor-like policy rules Yellen has written down and that feature a very aggressive response to such undershoots of the NAIRU. In short, it appears that, since the unemployment rate moved back down to the NAIRU, the Committee has not responded by raising the fund’s rate as it has in the past in other episodes of material undershooting. Given that we expect inflation to be slightly above 2% and the unemployment rate to be a percentage point below the NAIRU in 2019 and 2020,  we expect the FOMC to overshoot the estimated neutral rate by 50 basis points by 2020. This is a much smaller response than in the last two expansions, but we see reasons for a less aggressive response. (See Undershooting and Overshooting: Is This Time Different?

Fiscal Stimulus Meets Newtonian Monetary Policy 

Concerns about undershooting the NAIRU and overshooting the inflation objective will become heightened if there is fiscal stimulus, as it now appears there will be. Monetary and fiscal policies are coordinated, in a  sense. That’s what policy rules tell us. Fiscal policy is decided. Then the monetary policy is adjusted to (at least partially) offset the effect on aggregate demand. 

We have called this “Newtonian” monetary policy. For every action (e.g. fiscal stimulus), there is an equal and opposite reaction (e.g tighter monetary policy). Policymakers will never explain monetary policy decisions as a direct response to fiscal policy changes. Rather, monetary policymakers respond to how fiscal stimulus is expected to affect the macro outlook. In our simulations of our assumed fiscal package using FRB/US, the policy rule prescribed a couple additional of rate hikes by the end of 2020. That faster pace only partly offset the stimulus, however, leaving real GDP about half a percentage point higher. 

Financial Conditions and Monetary Policy 

There is another disconnect, one between the continued easing of financial conditions and the actual increases in the fund’s rate since 2015 and further expected increases. What to do? Try harder! This also points to a  hike in December and increases the prospect of four hikes in 2018. 

Financial Stability and Monetary Policy 

The official view under Bernanke and Yellen has been that macroprudential policy is the first line of defense against emerging financial stability risks. That reflects a narrow view of financial stability risks, that is, that 

the relevant risks are systemic risks arising from the banking sector. And that’s what macroprudential policy is about. But the Jeremy Stein view that financial stability risks could also arise from market developments— that is, from asset prices being detached from fundamentals and risk spreads narrowing to unsustainable levels—has been gaining traction. This is not about systemic risk, but these market conditions, if reversed quickly, can nevertheless be very damaging to the economy. While no one seems to be prepared to say financial stability risks have reached dangerous levels, the appropriate policy in this framework is to not wait until those risks get dangerous. Rosengren has been a champion of this view. This also appears to be the view of a number of other participants, including, importantly, the next Chairman, Jay Powell. 

The Macro Projections Do the Talking 

There will be important revisions in participants’ macro projections, and they will strengthen the case for a  December hike. Changes in the outlook have also raised the probability of four hikes in 2018, to the point where it’s now our call. 

First, the growth projection will be revised up a tenth or two for 2017, reflecting the apparent stronger-than-expected momentum in the economy, including 3.3% growth in Q3. The forecasts for 2018 and 2019 could be revised up, especially if more participants now include fiscal stimulus or raise the size of the assumed stimulus. If this is not the case, it might be because in response to fiscal stimulus and increased momentum participants assume a faster pace of rate hikes in 2018. 

Second, and most obvious, the path of the unemployment rate will be revised down, by about ¼ percentage point, reflecting not only improved growth prospects but also a releveling because of the faster-than-expected decline since the September meeting. 

Third, and perhaps the most important figure, will be the projection for core inflation in 2018. This will tell us if the Committee is taking more of a signal from the slowing in core inflation. If it remains at 1.9%, as in  September, or even moves to 1.8%, that will signal the Committee’s consensus is still that the slowing in core inflation was mostly temporary. That, of course, would be consistent with a December hike and would raise the prospect of four hikes in 2018. 

The Dots: On the Move 

We expect the 2018 dots to move up: fewer below three hikes, about the same number at three, more at four, and a couple now at five. That reflects increased concern about getting behind the curve. We still expect the median to remain at three hikes, however. But watch the trend! 

The Message in the Statement 

We expect the FOMC to upgrade the assessment of economic conditions in the statement. We expect the statement to refer to growth as “solid” once more; an upgraded assessment of business fixed investment; and a return to a standard favorable assessment of the labor market. The inflation language is likely to be adjusted in a nuanced way. In our guess of the statement, we simply took out the sentence that had referred to core inflation remaining soft in the most recent month. Core inflation in October was actually above expectations and promising. However, November CPI comes out on the second day of the meeting, and the  Chair will have the report in hand the previous afternoon. Plenty of time to tweak the statement.

Our Guess of the Statement 

Information received since the Federal Open Market Committee met in November September indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. despite hurricane-related disruptions. Although the hurricanes caused a drop in payroll employment in  September, Job gains rebounded in October after slowing sharply in September because of the recent hurricanes, and the unemployment rate declined further. Household spending has been expanding at a  moderate rate, and growth in business fixed investment has remained robust. picked up in recent quarters.  Gasoline prices rose in the aftermath of the hurricanes, boosting overall inflation in September; however, inflation for items other than food and energy remained soft. On a 12-month basis, both inflation measures overall inflation, and the measure excluding food and energy prices have continued to run have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low;  survey-based measures of longer-term inflation expectations are little changed, on balance. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricane-related disruptions and rebuilding will continue to affect economic activity, employment,  and inflation in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a  moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month  basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the  Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely. 

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation. 

In determining the timing and size of future adjustments to the target range for the federal funds rate, the  Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information,  including measures of labor market conditions, indicators of inflation pressures and inflation expectations,  and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate;  the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. 

The balance sheet normalization program initiated in October 2017 is proceeding. 

Voting for the FOMC monetary policy action was: Janet L. Yellen, Chair; William C. Dudley, Vice  Chairman; Lael Brainard; Charles L. Evans; Patrick Harker; Robert S. Kaplan; Neel Kashkari; Jerome H.  Powell; and Randal K. Quarles. Voting against the action were Charles L. Evans and Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.

Press Conference: A Fond Farewell? 

This will be Yellen’s last press conference, so we could see questions about transition and continuity regarding policy decisions. 

Market Response 

Not much, unless the statement is rewritten at the meeting to reflect a stronger November CPI report! Dissents 

Kashkari, who dissented for both rate hikes this year, will certainly dissent again. Evans, who is also dovish,  has not dissented this year and we saw him as reluctant to cast the second dissenting vote; however, given his recent strong words against raising rates, we think he’ll dissent.

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