Markets Are Witnessing a Yellen Fed at Its Humblest
It finally looks like when Federal Reserve officials say markets can expect multiple interest-rate increases this year, they really mean it. Even noted dove Chicago Federal Reserve President Charles Evans believes that another two hikes in 2017 is possible following last week's boost. Going one further, Philadelphia Federal Reserve President Patrick Harker left open the possibility of more than three total this year.
And yet the Fed has set the stage to be deep into the policy normalization process by the end of the year despite an inflation forecast that not only never cracks 2 percent but has repeatedly fallen short of its mark for years. The threat of inflation, not inflation itself, is what motivates the Fed after deciding long ago in favor of preemptive policy action to stay ahead of the curve.
Policy makers see themselves as dancing on a fine line. Too much tightening and they leave the economy weakened and vulnerable to negative shocks. Too little and they set the stage for inflation that they are unable to get under control. But if the Fed can hold that line, it will extend the life of this expansion and maximize employment over the medium to long run. Lacking precise policy tools, however, requires the Fed to seemingly lurch between hike and halt, leaving it open to criticism.
Federal Reserve Chair Janet Yellen summed up the Fed’s position in her Senate testimony last month:
As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.
Not everyone on the Federal Open Market Committee agrees. In explaining his dissenting vote at the March FOMC meeting, Minneapolis Federal Reserve President Neel Kashakari said:
Some argue that gradual rate increases are better than waiting and having to move aggressively. It isn’t clear to me that one path is obviously better than the other.
Why do most FOMC members disagree with Kashkari and see the path of early but gradual rate hikes as preferable? It is more of a practical rather than a theoretical concern. To my knowledge, there is no theory that claims the Fed cannot accelerate the pace of increases to reduce inflationary pressures without a recession as Yellen fears. In practice, however, the Fed has not proved particular adept at pulling off such a policy maneuver. New York Federal Reserve President William Dudley explains:
A particular risk of late and fast is that the unemployment rate could significantly undershoot the level consistent with price stability. If this occurred, then inflation would likely rise above our objective. At that point, history shows it is very difficult to push the unemployment rate back up just a little bit in order to contain inflation pressures. Looking at the post-war period, whenever the unemployment rate has increased by more than 0.3 to 0.4 percentage points, the economy has always ended up in a full-blown recession with the unemployment rate rising by at least 1.9 percentage points.
This is why the Fed does not want the forecast for unemployment to drift more than 0.3 percentage point below the estimate of the natural rate. Anything more and they risk being unable to quell an inflationary outbreak without a recession. And recessions are costly, something that is easy to forget now that unemployment is back below 5 percent. Back to Dudley:
This is an outcome to avoid, especially given that in an economic downturn the last to be hired are often the first to be fired. The goal is the maximum sustainable level of employment—in other words, the most job opportunities for the most people over the long run.
In a sense, this is the Fed at its most humble. Preemptive policy action is not borne out of a disregard for the jobless; it reflects recognition that they do not have the ability to fine-tune the economy. Arguably the tradeoff is not simply less employment for less inflation. It is between a little less employment now to minimize the risk of a whole lot of employment (and inequality) later.
Ultimately, this is the crux of the Fed’s challenge -- whether it is the employment mandate, the inflation mandate, or issues of financial stability -- what might seem best for the short run might not be best over the long run. The optimal tradeoff between the two might look easy to accomplish on paper (it’s just a matter of changing interest rates, right?), but in practical terms, the Fed needs to weigh the risks of favoring the former over the latter in the context of imperfect policy tools.
But while they may be focused now on the long-run, be wary that they might lurch back to the short-run. Market participants are losing faith in the Trump trade. A sharp downturn in equities this spring could delay the next hike just as the last surge moved it forward. More lurching, with reason. But that lurching means that both sides of the policy debate, those who think the Fed is acting too slowly versus those who desire further delay, like Kashkari, are likely to continue to be disappointed.
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