Yellen’s Fed Resigned to Diminished Growth ExpectationsRich Miller
Federal Reserve Chair Janet Yellen and her colleagues have lowered their sights on how fast the economy needs to expand to meet their goal of cutting unemployment.
No longer are they saying growth must accelerate from the 2 percent to 2.5 percent pace it has generally averaged since the recession ended. Instead, they are stressing the importance of preventing the expansion from faltering.
Exhibit number one: the Fed chief herself. Yellen said on April 16 that a key question facing the central bank is what “may be pushing the recovery off track.” Contrast that with her comments on March 4, 2013, of the importance of seeing “a convincing pickup in growth.”
The central bank on April 30 pushed ahead with its plan to gradually wind down its asset-purchase program in spite of news earlier in the day that growth ground to a virtual halt in the first quarter. Saying the economy is rebounding, the Federal Open Market Committee voted unanimously to reduce its bond purchases by another $10 billion a month, to $45 billion.
“Monetary policy has become very passive compared to where it was before,” said Neal Soss, chief economist at Credit Suisse Group AG in New York and a one-time assistant to former Fed Chairman Paul Volcker.
Most FOMC participants forecast gross domestic product growth of 2.8 percent to 3 percent this year and 3 percent to 3.2 percent in 2015, according to projections released March 19.
What’s changed is how they’ll react if this doesn’t happen. Rather than rushing out more stimulus if the economy falls somewhat short of their forecasts, policy makers probably will press ahead with cuts in asset purchases, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York.
“For tapering to go off track, we’d need to see things look pretty bad,” he said in an e-mail.
The reduced expectations for the economy also mean the Fed will be more inclined to raise its benchmark interest rate if growth comes in stronger than the central bank’s forecast, said Roberto Perli, a partner at Cornerstone Macro LP in Washington.
Investors are looking for officials to begin increasing rates in the second half of next year, according to trading in the federal funds futures market in Chicago. Perli said a rise could come earlier if the economy performs better than the Fed currently expects.
Behind the change in the Fed’s response pattern: the continued decline in unemployment and the rise of payrolls during what Yellen once characterized as a “disappointingly slow recovery.” The jobless rate fell to 6.3 percent in April from a 26-year high of 10 percent in October 2009, while payrolls have increased an average of 171,000 a month during the past four years.
That’s prompted policy makers to mark down their estimates of the economy’s potential growth rate: the speed at which it can expand over the long run without generating faster inflation while holding unemployment steady. Most FOMC participants pegged that rate at 2.2 percent to 2.3 percent in their March 19 projections. That’s down from the 2.5 percent to 2.8 percent range they saw in April 2011.
“We’ve gotten down to these unemployment levels in part because potential might be lower and in part because you’ve had four years of sustained growth of around 2 to 2-1/2 percent,” said Michelle Girard, chief U.S. economist for RBS Securities Inc. in Stamford, Connecticut.
Yellen alluded to the altered assessment in her April 16 speech to the Economic Club of New York.
“Our baseline outlook has changed as we have learned about the degree of structural damage to the economy wrought by the crisis and the subsequent pace of healing,” she said.
A combination of forces may be at work in reducing the economy’s long-run potential. Chastened by the deep economic slump, corporate executives have been slow to increase spending on factories, equipment, research and development. Startup businesses have been held back as would-be entrepreneurs find it harder to get financing. And out-of-work Americans have seen their skills atrophy the longer they’re without jobs.
Yellen suggested on April 16 that the reduced speed limit will have an impact on the level at which rates finally settle once the Fed begins to raise them. Its target for the federal funds rate on overnight loans between commercial banks has been zero to 0.25 percent since December 2008.
Most FOMC participants reckon that 4 percent is normal or neutral for the economy in the long run. Yellen, 67, said the Fed believes rates may need to remain below this level “for some time.”
“FOMC participants have cited different reasons for this view, but many of the reasons involve persistent effects of the financial crisis and the possibility that the productive capacity of the economy will grow more slowly,” she said.
“The neutral fed funds rate is edging down,” Girard said.
The median FOMC projection in March saw the rate rising to 1 percent at the end of 2015 and 2.25 percent a year later.
By lowering its assessment of how fast the economy can expand and conducting policy accordingly, the Fed runs the risk of locking the U.S. into a slow-growth path, said Tim Duy, a former Treasury Department economist who is now a professor at the University of Oregon in Eugene.
The Fed ramped up its quantitative-easing program late in 2012, helping to keep the recovery on track last year in the face of higher taxes and reduced government spending. With that drag set to fade this year, the central bank started to scale back its stimulus in December.
“They offset fiscal austerity on the downside but then arguably also offset the upside,” Duy said. “They seem to have lost interest in speeding the pace of the recovery.”
Soss said Fed officials may be realizing there are limits to how much they can spur growth in the aftermath of a financial crisis that’s made consumers and companies more cautious.
Some policy makers are becoming wary of the potential costs of providing more stimulus to the economy.
“We’re exactly on the right track” with current policy, Federal Reserve Bank of San Francisco President John Williams said in an April 21 interview, predicting unemployment will fall to 5.5 percent by the end of next year. Trying to achieve the Fed’s goals sooner “would take policy actions that might have more negative effects,” such as encouraging excessive risk-taking in financial markets.
History also suggests the Fed is prone to making policy mistakes if it fails to recognize that the economy’s potential is lower than it thought.
That’s what happened in the 1960s when the central bank pursued an overly easy monetary policy that led to the 1970s outbreak of inflation, according to research by former Fed official Athanasios Orphanides, who is now a professor at the Massachusetts Institute of Technology in Cambridge.
“If you lower the economy’s speed limit, it doesn’t take much growth to pass that speed limit,” Feroli said.