Citi: We'll Only Be Slightly Less Miserable When the Fed Declares 'Mission Accomplished'

When "as good as it gets" isn't very good.
Photographer: Chip Somodevilla/Getty Images

Imagine, for a moment, that the Federal Reserve finally gets what it's been after: full employment and its preferred measure of inflation stable at 2 percent.

What will have changed for the better?

For most Americans—and even for monetary policymakers—the answer is very little, according to Steven Englander, Citigroup Inc.'s global head of G10 FX strategy.

"There is a good chance that we will be only slightly less morose at 2 percent inflation than we are today," he writes in a note to clients. "The ultimate policy and asset market disappointment may occur when the Fed or another central bank hits its dual mandate and investors realize how many long-term issues remain."

When central bankers say they're aiming for stable inflation, what they actually mean is that they're trying to maintain a zero output gap. That is, they're aiming to have no difference between potential GDP—an estimate of the highest output an economy can produce without inflation taking off—and actual GDP.

The persistence of a negative output gap—cumulative actual growth falling short of potential—implies that disinflationary factors still dominate in an economy. For instance, in such a case there would be a vast number of people who would like to be working (or working more hours) but aren't able to. This excess supply of labor dampens the ability of people with jobs to demand higher wages, which would tend to increase inflationary pressures.

So-called Divine Coincidence, another economic theorem, holds that stable inflation (in this case, at 2 percent) is consistent with full employment and the absence of economic slack.

The use of an output gap framework is of dubious value to central bankers, according to some economic wonks such as FT Alphaville's Matthew Klein.

After all, it is an unobservable metric, as potential growth can only be estimated. But as a Toronto-based economist once said, the output gap is what central bankers continue to hang their hats on—because it's the only hook they've got.

Source: Bloomberg

When the U.S. economy finally closes its output gap, Englander says, the story will be one of downside risks avoided rather than upside surprises that abound. Inflation at 2 percent will be a necessary, but not sufficient, cause of a well-functioning U.S. economy.

"Well-functioning economies do not go into persistent disinflation or deflation, but that is not the same thing as saying that all economies with 2 percent inflation are well functioning," writes Englander. "Low investment, labor force participation and productivity growth are unlikely to disappear because inflation nudges up a few tenths of a percent."

Monetary policy is no panacea for these problems, nor is the "new normal" outlook for slow growth across the developed world, stemming from sluggish productivity and labor force growth, likely to change materially once the U.S. has vanquished its economic slack.

If the slower-growth environment endures, the Fed will still lack an abundance of room to maneuver interest rates lower to stimulate activity when the next shock hits, Englander argues. And in the event that maintaining this zero output gap requires rates only marginally higher than they are now, "such a low path may be consistent with either 2 percent inflation or asset market stability but is unlikely to be consistent with both," writes Englander in a nod to Larry Summers's "secular stagnation" thesis.


Central banks may be partially to blame for the misperception that economic conditions will be materially better than they are now when inflation is higher, Englander contends. To the extent that this true, it probably has much to do with the increased emphasis the Fed has placed on the wealth effect as part of the transition mechanism by which unconventional accommodation boosted activity when policy rates approached zero.

Asset price inflation, improving Americans' aggregate net wealth in the process, has been an explicit goal of Fed policy.

This combination of low interest rates and large-scale asset purchases laid a solid foundation for the improvement of household balance sheets that occurred during the recovery. But it can't do much to spur a higher trend rate for real growth.

"It may be more accurate to say that the economy at 2 percent inflation will be as good as it gets, but as-good-as-it-gets may be very mediocre," Englander concludes. "Expectations of currency strength and asset market stability are likely exaggerated as well."

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