The Fed Is Behind the Curve
Senior Federal Reserve officials have commented recently on how undesirable it would be if the Donald Trump administration implemented expansionary fiscal policy right now.
This new view is inconsistent with the Fed’s prior position that the labor market is not tight and that meaningful room remains for additional hiring. The Fed argued for some time that there still was plenty of slack in the labor market -- the central bank's primary justification for raising interest rates only very slowly over an extended period. If the Fed really believes that there is a lot of room for incremental hiring and that inflation will remain at bay for another two years, a more stimulative fiscal policy should be welcomed, not discouraged.
In my judgment, rates are too low and the Fed’s monetary policy is overly accommodative, and this will become increasingly apparent as inflation increases in response to economic growth that pushes unemployment even further below full employment. The Fed seems to be shifting its view and adopting that perspective, too, albeit slowly.
In testimony to the Senate on Wednesday, Fed Chair Janet Yellen indicated that she aimed to raise rates this year, regardless of Trump's plans for fiscal stimulus.
The Fed’s position for a few years has been that the economic recovery is modest, so there’s no urgency to hike rates. Yellen has repeatedly stated that a number of measures of the labor market imply significant excess supply of labor, despite the decline in the unemployment rate to levels that signaled full employment in the past. The Fed’s quarterly projections, released with the December 2016 minutes, indicate that the central bank does not expect to hit its 2 percent inflation target for another two years, reinforcing the notion that meaningful slack remains in the economy. Investors believe this message, so the bond market is priced for rates to rise only gradually over the course of the next few years.
This harmonious relationship is coming undone with the growing possibility that fiscal policy may become more expansion-oriented. Trump wants to cut personal and corporate tax rates and increase spending on defense and infrastructure. This may enlarge the budget deficit, even as it supports faster economic growth. Yet if the Fed truly believed the economy retains considerable slack, it would be logical for central bankers to welcome an expansionary fiscal policy. Instead, the Fed seems to be lobbying the new administration to avoid implementing an expansionary fiscal policy and pointing to the tight labor market as justification. The institution's stance on fiscal policy is incongruent with its characterization of the economy or its current monetary policy.
Indeed, its position on the economy seems to have changed directly in response to the new outlook for fiscal policy. The Barack Obama administration did not support expansion-oriented fiscal initiatives, leaving the job of promoting economic growth and reducing unemployment to the Fed. The central bank did a great job under Chairman Ben Bernanke and Yellen, reducing the unemployment rate to 4.6 percent, one of the lowest levels in many years, making up for the lack of fiscal stimulus coming from Treasury. However, the Fed has somewhat overplayed its narrative of a weak expansion in order to justify its still highly accommodative monetary policy. As the “modest” expansion (Yellen’s characterization of the economy, not mine) has been more than sufficient to bring down the jobless rate to levels that have historically been universally regarded as full employment, while wage growth and inflation have both increased only moderately so far. These processes have been underway long enough that the Fed should have started to gradually normalize rates earlier, but Yellen explained her preference to run the economy “hot” because material slack remained in the labor market.
No longer. Apparently, the mere prospect of a more expansionary fiscal policy is sufficient to cause the imagined slack in the labor market to evaporate almost overnight, even before any fiscal policy is articulated clearly in the form of proposed legislation. Indeed, during her speech before the Commonwealth Club of California a few weeks ago, she characterized employment as close to its maximum level and inflation as close to the Fed’s objective, quite a change of view within a short period of time. Nonetheless, in response to the very first question posed to her on the subject of income inequality, Yellen indicated quite clearly that the Fed has limited tools to reduce inequality, so she prefers a strong economy that would allow unskilled, unemployed workers to find jobs more easily. The Fed might wish to reduce income equality, despite lacking useful tools to help, but disappearing labor slack makes keeping rates low increasingly dangerous.
Simply put, the Fed is already behind the curve in normalizing rates. With a funds rate below 1 percent and a 10-year Treasury yield of around 2.47 percent, only marginally above the Fed’s official 2 percent inflation target, monetary policy remains highly accommodative. Even before the Trump administration can implement any of its fiscal programs, possibly even before it can fully express its fiscal plans, inflation may breach the Fed’s 2 percent objective. This has already occurred for all the primary inflation measures, except the Fed’s preferred measure, the core personal consumption deflator, which may also soon rise above 2 percent. In this context, it was very significant that Yellen suggested that a 3 percent funds rate represented a neutral monetary policy, since by its own projections, the Fed will not get there until 2019 or later.
Investors do not yet realize that monetary policy is too accommodative and that rates are too low. Bonds have sold off sharply since the election, as investors recognized that a more expansionary fiscal policy is coming. But the decline in bond prices has not yet allowed for the impending change that is coming from monetary policy, either because the Fed changes its tack, or because inflation kicks up well above the Fed’s tolerance. In fact, rates should move up significantly. And that will be a positive development, since it will more properly price the cost of capital to borrowers and provide better returns to investors.
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