Fed May Have Too Much Faith in Inflation Forecasts
Despite a low unemployment rate, inflation slowed this year, confounding central bankers who set in motion a tightening cycle on the expectation of firming prices. This leaves the Federal Reserve stuck in a quandary. Either transitory factors restrain inflation only temporarily, or perhaps expectations sink below the Fed’s 2 percent target.
If the former, the central bank can continue along the current path of gradual rate hikes. The majority of monetary policy makers lean in this direction. But if the latter, sticking to the current plan risks excessive slowing and even recession. It is the type of policy mistake we should fear in the mature stages of a business cycle.
New York Federal Reserve President William Dudley recently reiterated the consensus view among policy makers:
When combined with a firmer import price trend -- partly reflecting recent depreciation of the dollar -- and the fading of effects from a number of temporary, idiosyncratic factors, that causes me to expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term. In response, the Fed will likely continue to remove monetary policy accommodation gradually.
Dudley notes that long and variable lags for monetary policy require the Fed to act on the basis of the inflation forecast rather than actual forecast. If the unemployment rate is in fact close to or below its natural rate, as Fed officials generally believe, the upward pressure on wages and inflation still takes time to build and hence may not yet be evident. Moreover, in a likely deciding factor for Dudley, financial conditions have eased rather than tightened since the Fed began raising rates. Arguably, then, policy is falling behind the curve.
But should the Fed have so much faith in their inflation forecasts? Dudley’s research staff recently updated their DSGE model forecasts. While not official forecasts, they feed into the overall forecasting process. The inflation results continue to disappoint:
To be sure, there is tremendous uncertainty around these forecasts, but in general they indicate a continuation of the below-trend forecasts experienced since the recession. But considering the asymmetric policy concerns mean the effective lower bound, the ongoing possibility of deflation indicates considerable downside risk:
Dudley appears to be having none of this with his forecast, which calls into question his faith in this modeling technique. Cleveland Federal Reserve Bank President Loretta Mester, another proponent of the Fed’s current gradual tightening path, has an interesting way of dealing with the forecast uncertainty:
Since the 1990s, assuming that inflation will return to 2 percent over the next one to two years has been one of the most accurate forecasts. In the recent period, this is perhaps a testament to the importance of well-anchored inflation expectations and of the FOMC’s commitment to its 2 percent symmetric inflation goal.
In her view, unforecastable, idiosyncratic factors account for most of the error. Hence it is reasonable to just stick with the 2 percent forecast.
The trouble with that argument is that, as Mester notes above, it hinges on the stability of inflation expectations while the persistence of below-target inflation in the New York Fed’s forecast model suggests decline in expectations. So perhaps the post-recession forecast errors are less about idiosyncratic factors and more about sliding trend inflation?
This is exactly the hypothesis posited by Federal Reserve Governor Lael Brainard:
There is no single highly reliable measure of that underlying trend or the closely associated notion of longer-run inflation expectations. Nonetheless, a variety of measures suggest underlying trend inflation may currently be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective.
Brainard suggests that low inflation since the recession dragged down expectations, and that this may be related to the lack of policy space due to low natural rates of interest, which hold down rates and increase the likelihood of hitting the effective lower bound.
If Brainard is correct, then the Fed should be very wary of further rate increases. Not only does a low neutral interest rate imply further tightening is unnecessary, but the central bank also needs to work at pulling up inflation expectations if it expects to meet the 2 percent target. Specifically, Brainard says:
I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time.
Market participants should watch for signs that Brainard’s view takes hold more widely, particularly with Federal Reserve Chair Janet Yellen. They imply a much more dovish path of policy than warranted by the current projections of one more hike this year and three next year; a more dovish path would tilt the Open Market Committee toward the expectations of market participants. But also watch for signs that Brainard is correct but ignored by her colleagues. The consequences would be excessive tightening with the possibility of recession. In this case, look for the early evidence of impending recession in an inverted yield curve as longer rates stubbornly refuse to follow short rates higher.
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Max Berley at email@example.com