The effectiveness of the Federal Reserve’s communication strategy is clearly questionable when the outcome of a Federal Open Market Committee meeting is considered a coin toss among economists who closely follow monetary policy.
What’s missing from the central bank’s communication strategy?
In my opinion, the blame lies at the feet of Janet Yellen, who chairs the Federal Reserve.
Yellen appears to have been effective at shifting the policy debate within the FOMC in her direction. But she’s been less effective at forming a consensus about the near-term guideposts for policy. The lack of such a consensus leaves only the Fed’s estimate of the natural rate of unemployment as the key goalpost—and the U.S. economy has already crossed that goal, for all intents and purposes.
So if that is not the objective, what is? That’s what we need from Yellen.
First, why is the natural rate of unemployment the goalpost? Why not inflation? The key is remembering that the Fed retains a 'Phillips curve' view of the world.
From Yellen’s press conference on Sept. 17:
Now, in the inter-meeting period, we have seen some further appreciation of the dollar and some further downward pressure on energy prices. And that creates a bit of further drag on inflation that I would view as transitory, is very likely to be transitory. So I continue and the committee continues to expect that inflation will move back to 2 percent, so this should be a small thing. And in the meantime, the labor market has continued to improve, so a tighter labor market, a labor market moving toward full employment is one that historically has generated upward pressure on inflation. So that bolsters my confidence in inflation.
In other words, the near-term downward pressure on inflation is most likely temporary; in the longer run, unemployment near the natural rate will push inflation back to target. That longer-run view on the unemployment rate is thus the most critical goalpost.
What is Yellen’s estimate of the natural rate of unemployment?
Policymakers generally resist revealing their own estimates. But given that the Fed's range of forecasts runs from 4.7 percent to 5.8 percent, it’s safe to say that Yellen’s lowest possible estimate is currently 4.7 percent. In other words, unemployment is currently sitting right on top of what must be near the lowest of Yellen’s possible estimates of the natural rate. And not only is unemployment sitting close to her estimate of the natural rate; it will almost certainly plunge below that level in the months ahead.
We also clearly know that Yellen prefers to be ahead of the curve on inflation. From the press conference:
So, if we maintain a highly accommodative monetary policy for a very long time from here and the economy performs as we expect, namely it's strong and the risks that are out there don't materialize, my concern will be that we will have much more tightening in labor markets than you see in these projections and the lags will be probably slow, but eventually we will find ourselves with a substantial overshoot of our inflation objective and then we'll be forced into a kind of stop-go policy. We will have pushed the economy so far it will have become overheated. And we will then have to tighten policy more abruptly than we like. And instead of having slow steady growth improvement in the labor market and continued improvement in good performance in the labor market, I don't think it's good policy to have to then slam on the brakes and risk a downturn in the economy.
If you believe that the natural rate of unemployment is 5 percent, and you believe that policy needs to move ahead of inflationary pressures, you probably should have hiked rates in June, at the latest. Hence, as it seems to many market participants, the Fed is setting guidelines it doesn’t follow.
But there is another set of measures. Back to Yellen:
As I said, although we are close to many participants and the median estimate of the longer run normal rate of unemployment, at least my own judgment, and this has been true for a long time, is that there are additional margins of slack particularly relating to very high levels of part-time involuntary employment and labor force participation that suggests that at least to some extent the standard unemployment rate understates the degree of slack in the labor market. But we are getting closer.
This is the Yellen the dove, the Yellen of 2014.
This is the Yellen who emphasizes the importance of measures of underemployment when assessing the Fed’s policy stance. And that Yellen is not so eager to react blindly to the 5 percent natural-rate guideline. She is pulling the actual policy of the committee away from the stated goal of the committee.
Later she adds:
As the labor market heals and as that healing progresses, we will see further upward pressure on inflation. That’s what we expect. Now, it’s a slow process, it's characterized by lags and that's why it takes a few years as the inflation, as the unemployment rate falls and even overshoots its longer-run normal level, it just takes some time for inflation to get back to 2 percent. But the overshooting helps it get back faster than it otherwise would, and it is certainly important for us and I think our credibility hinges on defending our inflation target, not only from threats that it rises above but also that we not have—that over the medium-term that we want to see inflation get back to 2 percent. And we believe the policies we're following are designed to accomplish that and will do so.
To accelerate the return of inflation to target, Yellen believes policymakers need to overshoot the natural rate of unemployment. That overshooting is the gray area. There is no clear, near-term standard like that of the longer-run natural rate of unemployment at 5 percent. She hasn’t built a consensus on that near-term target. But she keeps pulling the committee to whatever is her view of that goalpost. And, I suspect, that goalpost is changing.
What might be Yellen’s current near-term objective for unemployment?
Again, we don’t know her forecast for certain, but the lower bound of the 2016 unemployment forecasts is 4.5 percent. Assuming that is Yellen’s forecast, the figure implies she would be hesitant to allow the unemployment rate to drop much below 5 percent before giving the green light to the FOMC hawks, who so desperately wanted to embark on the normalization process sooner than later. That keeps a December hike on the table It is very much on the table, in fact—but only assuming the goalposts don’t shift again.
Bottom Line: I suspect Yellen is pulling the committee toward her position, but she is hesitant to define that position publicly. This, I think, is the central problem with policy communication as the Fed navigates the inflection point between the zero bound and a rate increase. If Yellen is the key force within the FOMC, then it is increasingly important, from a communications perspective, for her to take ownership of policy. We need a clear picture of Yellen’s policy reaction function. Her 'dots' are too important to not be revealed if the Fed is to effectively communicate policy. What are her goalposts and how do they move? Hopefully she will provide some clarity on these points in her speech on Thursday.
The author is the professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
Correction: This article has been amended to include the Fed's latest range of forecasts for full employment.