Goldman: Don’t Count on Janet Yellen to Let the Economy Run Hot

“Optimal control” was a 2012 story.

Fed's Bullard on the U.S. Economy, Dollar, Inflation

The Federal Reserve wants to see inflation run up a bit, according to a number of economists. Goldman Sachs is skeptical.

The expectation, which Fed Chair Janet Yellen has pooh-poohed, has intensified since March. That’s when members of the Federal Open Market Committee, the U.S. central bank’s policymaking panel, sliced in half the number of interest rate increases they deemed appropriate by the end of 2016 from their December estimates. In an interview with Bloomberg TV, St. Louis Fed President James Bullard indicated that an overshoot of inflation was part of the central bank’s forecast.

Proponents of the theory often point to a speech Yellen delivered in April 2012, when she was vice chair, in which she outlined a technique for the normalizing of monetary policy known as the optimal control method. It involved letting the pace of price increases rise above the Fed’s 2 percent target. If adopted by the central bank, the method would have constituted a pledge to bring down the unemployment rate faster while accepting above-target inflation. In other words, a commitment to stay behind the curve—for a while.

In a note to clients, Goldman Sachs Group Inc. Chief Economist Jan Hatzius throws cold water on the idea that Yellen remains married to the method she flirted with more than four years ago, and warns it risks misleading investors.

“The benefit of this strategy occurs in 2012 and in the years thereafter, as the easier policy stance helps the economy recover more quickly than it otherwise would,” Hatzius writes. “The cost of the strategy—assuming that the Fed does what it signaled—is that the economy eventually overheats, inflation moves above the target, and the exit becomes steeper and potentially more disruptive.”

This isn’t 2012, Hatzius notes. The labor market has recovered substantially since then, and though the most recent inflation prints have proved discouraging, measures of price pressures are generally accelerating, rather than decelerating as they did in 2012.

“The economy is no longer far from full employment,” Hatzius writes, “and this makes it unattractive to accept a future inflation overshoot in return for greater stimulus now.”

Full employment has been something of a moving target. The pace of average hourly earnings growth is below desired levels, and the labor force participation rate is ticking higher. Recent dynamics in the job market would seem to only increase the resolve of a monetary policymaker who thinks letting the economy run hot would allow for the deepest possible healing in the labor market.

Hatzius’s point, however, is that with a tightening phase already under way, the presumptive benefits of the 2012 optimal control path likely aren’t worth the risk of an abrupt tightening that sends the U.S. economy into recession.

Another version of the Fed-favors-an-overshoot argument goes as follows: Inflation has run below the central bank’s target for an extended period of time, and survey- as well as market-based measures of inflation expectations have slipped. Monetary policymakers might find it prudent to let the economy run a little hot so the 2 percent target is credibly viewed as symmetric.

The merits of this case are much stronger, Hatzius notes, though it’s unclear how much of an overshoot the Fed might be willing to tolerate.

“It is easy to overemphasize the importance of the shift [in monetary policymakers’ possible willingness to let inflation run high] in a way that risks lulling investors in a false sense of security,” he writes. “After all, the FOMC would still want to prevent the overshoot from getting too large, and would therefore undoubtedly tighten policy more quickly in an overshooting scenario than in the baseline.”

From a market perspective, optimal control was in vogue around the time Yellen laid out the merits of the technique. The narrative of “less tightening now, more tightening later” was embedded in the overnight index swaps curve in 2012. But the winds have since shifted many times. In 2014 the OIS curve could be better described as looking for “more tightening soon, less tightening later.”

At present, the market is decidedly not priced for an optimal control-like path. “Less tightening now, and not much more later” is the conventional wisdom du jour, as this chart from Bloomberg’s Matthew Boesler shows:

Source: Bloomberg

The Fed was expected to be raising rates at a faster pace in the medium term than it was in the short term in 2012. Two years later, this situation was turned on its head. Nowadays the OIS futures curve is pricing in a pace of about one hike a year.

In the event that the Fed hits the snooze button on responding to inflationary pressures, market participants will face a disturbing wake-up call, according to Hatzius.

“Tolerating an overshoot does not mean ignoring it when setting policy,” he concludes. “We believe that even a limited inflation overshoot could result in a significantly steeper pace of funds rate normalization than priced into the front end of the yield curve.”

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