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The dove in the dots: paving the way for a US inflation overshoot
Does the FOMC hope that with only moderate policy tightening, it can eventually succeed in returning US inflation to objective after an overshoot?
- FOMC communications and projections suggest that policymakers are largely accommodating fiscal expansion and possibly encouraging an inflation overshoot.
- Still, quarterly policy rate increases through end-2019 remain likely as the unemployment rate will continue to fall below the Committee’s projections.
- Longer-term, there is little clarity about how the Committee will cool off the labor market. Redefining full employment by continuing to revise NAIRU lower will become less tenable if inflation continues to firm.
At the June Federal Open Market Committee meeting, policymakers raised the target range for the federal funds rate by 25 basis points and in the Summary of Economic Projections (SEP) signaled a slightly steeper path for the federal funds rate through year-end 2019.
The shift in interest rate projections has generally been described by Fed watchers as a hawkish tilt by the FOMC, with the Committee gradually tightening policy in response to above-trend growth, a tight labor market and slightly above-objective inflation. However, this narrative misses the more important evolution in the Committee’s thinking about the optimal path for the economy in the face of fiscal expansion.Specifically, relative to the significant change in macroeconomic projections since last fall, the change in interest rate projections over the same period has been quite limited. This growing contrast between the economic and policy rate projections suggests that the Committee is largely accommodating fiscal stimulus rather than pushing against it to prevent the output gap from moving further into positive territory and the unemployment rate from falling further below the Committee’s estimate of NAIRU.
As a result, the shift in interest rate projections in the SEP relative to the shift in macro projections should most appropriately be considered dovish. This dovish stance in turn suggests that the risks of the economy overheating over the medium term are rising.
Change in Policy Rate Projections, September 2017 to June 2018
Source: Board of Governors of the Federal Reserve System, BNP Paribas Asset Management
Exploring the dovish tilt
Significant fiscal expansion at a time when the economy is largely operating at or beyond full employment represents a challenge that the FOMC could not have anticipated when it embarked on its strategy of gradual policy normalization in 2015. Furthermore, even as the administration prioritized tax cuts, it would have been challenging for the Committee to speed up its pace of policy normalization while passage of the tax package remained uncertain.
In addition, the first half of 2017 brought an unanticipated decline in inflation that precluded a quickening of the pace of policy tightening. As a consequence of these considerations, at the time that the Tax Cuts and Jobs Act (TCJA) finally became law, policy remained highly accommodative for an economy with a closed output gap and very low unemployment that was also on the verge of a significant fiscal expansion.
Once the TCJA was enacted, the Committee could have pivoted to offset fiscal stimulus more forcefully and limit risks of the economy overheating over the medium term. As such, the decision to stick to a gradual pace of normalization despite a very different economic outlook should be viewed as a policy choice.
This begs the question of why the Committee is pursuing a strategy of a significant NAIRU undershoot for the unemployment rate and above-objective inflation. There are several explanations. One rationale that Committee participants have cited in recent months is the need to reinforce the notion of symmetric treatment of the two percent inflation objective.
As the FOMC began raising the policy rate at a time when inflation was still running below two percent, it is possible that the public began to view a two percent rate of inflation as the maximum amount that the Committee would tolerate. Seen in this context, tolerating or even encouraging an inflation overshoot could reinforce the notion of a symmetric objective and re-anchor inflation expectations at two percent.
Another rationale for accommodating fiscal expansion and a very tight labor market stems from the likely contour of growth over coming years. The growth impulse from fiscal policy will begin to fade starting in 2020. Aware of this, the Committee may not want an overly restrictive policy stance by that time, as growth will be decelerating back towards trend. Under this strategy, the Committee may expect that a slightly restrictive policy stance from 2020 onward will be sufficient, over time, to cool the labor market and ensure inflation stabilizes around the objective.
Uncertainty regarding NAIRU is another factor behind the Committee’s decision to stick to a gradual path of rate increases even as the unemployment rate is expected to fall to, if not below, levels last seen in the 1960s. The fact that the rate of core inflation is no higher now than it was 18 months ago, when the unemployment rate first declined below the Committee’s estimate of its longer-run level, suggests that uncertainty over the true level of NAIRU likely still remains high.
Finally, for a number of years now, the Committee has been examining the policy implications of a natural rate of interest, or r-star, that appears to have declined over the past decade and is likely to remain depressed for the foreseeable future. One implication is that the current tightening cycle is likely to end with a relatively low level of the policy rate compared to prior cycles, and hence the ability to cut rates in the next recession could be limited.
This longer-term risk, combined with uncertainty about the true level of r-star, suggests that the Committee may be particularly careful in raising rates. In addition, a low level of r-star implies that all else equal, the Committee might prefer to enter the next recession with a somewhat elevated level of inflation in order to create additional space for cutting the real policy rate below zero.
The way forward
Communications from policymakers as well as the evolution of the SEP all paint a picture of a Committee that is largely accommodating fiscal expansion and possibly encouraging above-tobjective inflation.
But even as the Committee is comfortable with an inflation overshoot, there are limits to its tolerance. It is highly unlikely that the Committee will tolerate persistent inflation above 2.25%. At a certain point, the Committee will become concerned about inflation expectations becoming unanchored to the upside, and would also grow more concerned about potentially non-linear inflation effects associated with extremely low unemployment – the so-called kink in the Phillips curve.
In addition, inflation above 2.25% would likely come about as a result of shelter inflation rising significantly above two percent, and it could be challenging for the Committee to slow meaningfully the pace of housing costs without causing a recession.
With this 2.25% threshold on above-objective inflation in mind, it is worth considering how policy will evolve in the near term. The Committee is likely still underestimating just how low the unemployment rate will fall. This is somewhat surprising given that most Committee members seem to appreciate that the labor force participation rate is unlikely to rise in the years ahead. With few also assuming a pickup in productivity, persistent above-trend growth suggests that the unemployment rate could meaningfully undershoot the median Committee participant’s projection of 3.5% for end-2019.
As this becomes apparent, the projections will reflect additional policy tightening. The next 18 months are therefore likely to see an additional 150 basis points of cumulative tightening: two more 25-basis point rate increases this year, and four next year. Thus even with a dovish shift in the reaction function, the SEP rate path is likely to show additional steepening in future projection rounds as the unemployment rate shows sustained downward momentum.
Even with a steeper eventual rate path, there is still no clear indication of how the Committee will eventually shrink the positive output gap and cool off the labor market over the medium term. The 2020 median projection suggests that the unemployment rate will still be far below all Committee members’ NAIRU estimates, but with the projected policy rate just marginally in restrictive territory. This suggests that either the Committee will continue to tighten policy in 2021 or that inflation could rise more meaningfully above two percent.
At the June press briefing, Chairman Powell was asked about plans for returning the unemployment rate to NAIRU over the medium term, and he did not provide a clear answer. His response instead focused on uncertainty over the level of NAIRU and the possibility that NAIRU could be revised lower. However this will be an unconvincing approach for addressing the issue of a persistently low (and still-falling) unemployment rate if indeed inflation rises above two percent. In the meantime, the September SEP may provide important clues as to how the Committee plans on avoiding an overheating in the years ahead. In September, the SEP projections will roll forward another year, to 2021.
If the median projections for that year show no additional rate increases but a higher unemployment rate projection than for 2020, it would confirm that the Committee hopes that with only moderate tightening it can eventually succeed in returning inflation to objective after an overshoot that will likely extend beyond the projection horizon.
On credit, emerging markets and the US dollar
If you can, help others; if you cannot do that, at least do not harm them. - Dalai Lama Summary The Sino-US trade tension risks escalating to a new cold war, which could cost not only China and the US, but also the world economy, dearly. Collateral damage to the global system could be another round of currency war in the short term with new volatility dynamics coming from China. If the end of the last Cold War fostered global economic integration, the beginning of the next one - between China and the US - will likely produce fragmentation, with long-term consequences on even technological innovation and climate change.
The primary themes impacting the yields of US Treasuries and the pricing of future levels of inflation (via breakeven inflation rates (BEIs)) have changed little in the last few months. They continue to generate a range-trading environment for US Treasury bonds and TIPS.