The Fed Is Losing Focus of Its Primary Mandates
Core leadership at the Federal Reserve appears determined to normalize policy via interest-rate hikes and balance-sheet reduction. But they have run up against a significant roadblock because the inflation data stubbornly refuse to cooperate with their forecast. Don’t expect that to deter leaders of the U.S. central bank just yet. They generally view the inflation weakness as transitory. A labor market circling around full employment serves as the justification they need to keep their foot on the brake.
And if that weren’t enough, they can pivot their focus toward financial stability. Indeed, that’s already under way. But be warned: That road will almost certainly lead to excessive tightening. In it you can see one path by which this expansion comes to an end.
The inflation data has disappointed in recent months, pulling the annual rate lower and away from the Fed’s target. But that did not stop the bank from raising rates in June, setting the groundwork for balance-sheet reduction, or holding steady the projected path of future rate increase in their summary of economic projections. Instead, they dismissed the inflation shortfall as a temporary setback and focused on the medium-term forecast. A helpful focus given that the inflation forecast always reverts to 2 percent.
Not all Fed officials are falling into line. Minneapolis Federal Reserve President Neel Kashkari dissented at the June meeting. And although Chicago Federal Reserve President Charles Evans did not dissent, concerns over persistent disinflationary pressures leave him wary about the future path of rates.
Yet Fed Chair Janet Yellen gave little ground in her recent post-Federal Open Market Committee meeting press conference, leaving no doubt the Fed intended to continue tightening policy. In the context of their Phillips curve-driven framework, this is almost unavoidable, as officials fear that inflation will suddenly lurch higher if the economy drifts too far below full employment. The Fed will retain an overall tightening bias as long as there remains sufficient economic strength to place downward pressure on unemployment.
Still, one would reasonably think that low inflation would eventually worry a central bank with an inflation target. Indeed, the minutes of the June FOMC meeting noted that “several” participants were concerned that recent inflation weakness would be more persistent than transitory. If such concerns appear justified as the year continues, and especially if combined with a softer labor market, the Fed will reduce its projected path of interest rates.
But the Fed has another worry -- that of financial instability driven by a persistent low-interest-rate environment. That worry was on clear display in recent weeks. Yellen described asset prices as “somewhat rich.” Vice Chair Stanley Fischer worried that low interest rates are driving home prices higher. And New York Federal Reserve President Bill Dudley warned that the Fed needs to account for the “evolution of financial conditions” when setting policy. Also, June FOMC meeting participants noted that financial conditions had eased even as the Fed reduced policy accommodation. Some thought equity prices were high relative to valuations, others saw high risk tolerance among investors, and a few worried directly about financial stability risks.
A pivot toward financial instability by the Fed throws up a lot of red flags. First, although it is basically conventional wisdom at this point, it is not obvious to me that low rates alone are the cause of such instability. For example, the run-up in stock prices that preceded the October 1987 crash took place in an environment of interest rates above 7 percent. Likewise, the federal funds rate never dipped below 4.75 percent in the latter half of the 1990s during the dot-com boom.
Second, even if you concede that low rates alone are fueling financial instability, the Fed might not be able to moderate financial market excess without crushing the economy. Economists at the Federal Reserve Bank of San Francisco estimated that to curtail the housing bubble, the central bank would have needed to raise their policy rate by 8 percentage points in 2002. That would have certainly toppled the economy into recession well before 2007.
A final problem with a pivot toward financial stability concerns as justification for hiking rates is that the Fed lacks a corresponding policy framework to guide such decisions. The central bank’s reaction is essentially a Taylor-type rule with a framework of the dual mandate of 2 percent inflation and maximum employment. There is no financial stability variable within this framework.
What this means is that if the Fed decides it needs to target financial stability with rate policy, it is essentially flying blind, operating without either established policy or communications frameworks. A reliance on unobserved variables -- the natural rates of interest and unemployment and potential output -- already creates a challenge for policy makers. Adding another ill-defined concept of financial stability only worsens that challenge.
When central bankers lose focus on their primary mandates -- inflation and unemployment -- the odds of a policy mistake rise sharply. Remember that the most likely cause of a sustained drop in asset prices will be a recession and the associated fall in profits. That means that if central bankers wait until asset prices roll over before they stop tightening, they have almost certainly waited too long. I don’t think the Fed is in imminent danger of making such a mistake, but I can see the genesis of such a mistake if the bank turns rate decisions too much toward financial stability concerns.
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