Schematic of Fed policy
Fed
Schematic (1) How the Fed thinks the world works
Unemployment Labor
Rate ---à marketà Wages -à Prices à Fed Funds -à ActivityàPrices
Fed
Schematic (2) How Policy Works in this world
Unemployment
Rate -à Labor Market -à Wages-à Pricesà Fed Funds
DIMINISHED
IMPACT ON WAGES and PRICES
Schematic
(3) How the Fed/economy has really been
working
Unemployment
Rate -à ???
-à Wages-à Pricesà Fed Funds
Fed skips wait for pass-through, assumes it and hikes Fed Funds
on the basis of a low U3-rate alone
Since the Fed believes that
the world works one way {Schematic (1)} it makes policy on that belief.
Seeing the unemployment rate
so low, the Fed assumes that the process is underway and DOES NOT WAIT to see
inflation emerge before it hikes rates Schematic (2). But we have a
PROLIFERATION of information that question whether that transitional process is
really still operative, Schematic
(3).
Problems
Evidence suggests that the unemployment rate is not the same variable
it used to be…
Participation
rate changes show some of the labor force characteristics are changing
As
the labor force ages its characteristics change’ productivity changes, many
aspects change
Not
surprisingly…
There has
been a big shift. The participation rate has come to explain the bulk of the
shift in the unemployment rate. This did not used to be the case (see below).
This shift should cause us to wonder the nature of unemployment rate itself. If
shifting demographics rather than rising employment or falling unemployment is
the main determinate of the rate of unemployment, hasn’t the nature of that
rate changed? It is a question the Fed seems to entertain in policy discussions
and in speeches BUT NOT in the application of policy itself. That’s odd.
In
addition there have been non-demographic shocks as people, not just those in
the upper age cohorts, have reduced their willingness to participate in the
labor force as either employed or unemployed persons. The U6 rate is more
inclusive as it encompasses a broader view of what people are jobless.
While the
unemployment rate (U3) has fallen, the U6 rate has not fallen nearly as much.
The charts (above and below) show very different views of the world. The U3
rate is rarely lower and so the Fed fears (AKA is ‘sure’) that schematic number
one is in play. It is ready to act as in schematic number 2 to jump interest
rates on the reality of a low U3 rate fearing inflation is coming… But the
unemployment rate ratio of U6 to U3 shows us that the U6 rate has not fallen
nearly as much. It reminds us that by a
different measure there is a lot more slack in the economy than U3 suggests. By
that I do not just mean that the U6 is higher. It is both absolutely and
relatively higher. The ratio is higher. And that is significant. If there is
more slack a lower U3 rate might not create so much wage pressure. Anticipatory
rate hikes might be ill conceived.
U3 is
rarely lower. And the Fed is worried that such a low unemployment rate implies
with NEAR CERTAINTY inflation is on the way. So the Fed is taking the
OPPORTUNITY of growth that it sees as being more stable and reliable to HIKE
interest rates from super low levels. Still the chart above also informs us of
another interesting peculiarity. In the Post-War period when the U3 rate has
been this low a recession has been ‘just around the corner.’ In fact recessions
have occurred from much higher levels of unemployment than what we have today. On
average since 1950, recession has occurred with about 2 ½ years of the
Unemployment rate (U3) first breaking the 4.8% mark. But lead times have been
as short as two months and as long as nearly five years. So there is the
question of if the Fed thinks that the old U3 rate is just the same old thing
or not? Does this explain why the Fed is hiking rates? Is it because it fears a
recession is around the corner and the Fed feels a need to get rates higher?
Does it really fear inflation? …Inflation that is not really developing? What
is the Fed’s real rationale for what it is doing? I get the sense that the Fed
is running words past us that derive from an old paradigm that no longer works
and is not relevant.
How we
should measure the unemployment rate has become a controversial subject, but we
also know that what the unemployment rate DOES has shifted. In short the Fed’s
policy of leap-frogging the impact of the low unemployment rate to head off
inflation (that may not be in train) is a policy tact without strong rationale
anymore. For an institution with more economists than you can shake a stick at
this is a brazen disregard of some basic economic facts. Let’s look at
some.
More Problems: Stylized facts about the
unemployment rate…
The main
relationship that maps the unemployment rate and its changes into inflation
works through wages and is called the Phillips curve. But the Phillips Curve
relationship has become flat. It has shifted down and it does not depict a very
POWERFUL relationship between unemployment and inflation. It certainly does not
begin to explain why the Fed is so dogmatically out of sorts about the low rate
of unemployment. On the chart above
the unemployment rate can fall from 7% to 4% and wage rate inflation will rise
from about 2% to about 2.7%. However, the lowest unemployment rate we have seen
since 1950 is 2.5%.... a rate that low would result in a drop in the unemployment
rate by only another 2.3 percentage points, and some modest additional wage
pressure. Is that what the Fed fears?
In
addition, other relationships have shifted. Here we see that there is still a
relationship to wages through a heightened quit rate but that that relationship
is also is less powerful. It has shifted downward and the slope depicting the
impact of change in the quit rate on the change in wage inflation is diminished
as well (the slope of the line is flatter). Market power has shifted away from
the worker even when the job market tightens. Firms are reluctant to raise
wages because of international competition and are further empowered to hold
back wages hikes because technology has given them more options. Note that we
get these muted relationships even though, in recent years, government
legislation has had a role in pushing wages up though increases in the minimum
wage rate as the unemployment rate fell.
Those hikes are still in progress.
Moreover
the ‘trigger’ for inflation creation in this model is a dropping unemployment rate
and the chart above shows that the pace of the unemployment rate drop has
slowed to crawl and we might even wonder if it is still in train…
Conclusions, observations and a policy
recommendations
In the 1980s
when inflation was high the Fed adopted a monetary approach to monitoring inflation
and to setting monetary policy. In the early 1980s Fed policy tightness rose
and fell on things like money supply and bank reserves. Under Alan Greenspan
the Fed lost its theoretical focus and began heuristically to follow his mantra
which was that inflation should be as low and close to zero as is practically
possible. Under Ben Bernanke the Fed drifted on the same path for a short while
until Bernanke got the Fed to adopt inflation targeting on the heels of the
same approach used by the ECB and the BOE. This policy, which like Greenspan’s
method, is output oriented (targeting inflation itself) rather than input
oriented (aimed at controlling the money supply and bank reserves that create
inflation). Inflation targeting is also meant to corral the benefits of
focusing expectations on the target. If the central bank has credibility and
demonstrates that it hits its inflation target, the more likely it is that the
transactors in the economy will build that expectation into what they are doing
so that the target becomes more robust and more easily achievable.
Leader as follower- Janet Yellen’s recent
speech (March 3, 2017) began on the note the Fed likes to reinforce which is that
the Fed is merely following the mandate laid down by Congress. But in fact the Fed
has a great deal of flexibility in how it achieves its dual mandate for price
stabilization and sustaining low unemployment. The Fed has chosen to use
inflation targeting and to adopt all the layers of communication problems that
resulted when it chose to implement Congress’ directives by dabbling with the
notion of employing policy guidance.
Fed policy makes more sense than the
rationale for Fed policy…The Fed insists on a policy paradigm that focuses
on its ability to achieve its unemployment rate and inflation objectives. These
are two goals that often find themselves in opposition. For now the Fed is in
the position of having both metrics reasonably close to their goals. For the
moment the Fed acts as if the unemployment rate can’t fall much further (or that
it shouldn’t) and that inflation is still not quite high enough, but is almost (…and
soon will be). However, all that is a lot of hair-splitting. The ongoing bump up
for inflation is oil-price-related which the Fed has told us it usually tries
to ‘look through’ (as the ECB is doing). Core inflation is really not rising. And
the unemployment objective is for a rate that is flawed and of unknown merit as
we document above. Core inflation shows little pressure and is a bit farther
below its target of 2% than the headline (which is at 1.9%). But in economics
given leads and lags and other variabilities one has to conclude that inflation
is reasonably close to target. YES… it is technically below target and has been
below target for many, many, months (57, but who’s counting?). Still, policy is
really close to being in its ‘sweet spot. Policymaking is about looking ahead
even if one does not drink the Fed’s Kool Aid on its need to forecast ahead. By
looking at the position of the economy in the business cycle and at the level
of the rate of unemployment, the Fed can make assessments of trends and of
economic needs and decide on the fine tuning of making policy. So what should the Fed be doing?
What Janet Yellen should do for her winter
vacation: change the way she operates: The Fed should be focusing less on
the hairsplitting notion of getting inflation back to 2% and on getting each of
its variables precisely on target and focus more on having policy get rates
back into a configuration that looks more like normalcy. Since growth is simply
not going to get as strong as it used to, GDP growth around 2% is now
good-to-normal. The Fed should be less concerned about whether the labor market
is going to tighten, raise wages and boost inflation and instead be more
focused on the fact that its main policy variables - even with all their issues-
are relatively close to where they ‘should’ be and declare victory so policy
can carefully -CAREFULLY- nudge the Fed funds rate back toward normal. The Fed
in displaying the DOTS should focus MORE on a POLICY corridor from the dots
than on the median or average of the dots (trimmed or otherwise). I know many
will read this and say but that is what they are doing. Yes, it is sort of….
But this is not the justification that the Fed is using and the policy approach
is important. The Fed has to step out of the particular partition of the Japanese
lunchbox of policy options it has set for itself and look at the whole lunch.
If it were to do this it could free itself of the straight jacket of the
language it has adopted and actually have the flexibility to implement policy
within essentially the same framework. Right now policy is too myopic, too literal,
too mechanistic and too technically oriented on policy parameters of unknown
quality. The Fed needs to stop pretending that the job market, the unemployment
rate and the Phillips curve are a good way to run policy. They certainly are
not. And the sooner that the Fed jumps off that band wagon the better.
It’s not brain surgery...it’s about
alligator arms (or, more simply, STOP Over-reaching!)
The Fed needs
to use a blunter pencil when assessing its own performance. If we knew that
(1)
2% were exactly the right inflation rate,
(2)
the PCE were the exact right inflation gauge,
(3)
the U3 rate were the right unemployment rate and
(4)
where the proper U3 level stood,
then,
policy would be (somewhat) easier to conduct.
But in
fact we know none of these things - NONE. That’s why I think that Fed should declare
victory and move on to focus on the right path or speed for getting the Fed
funds rate back to (or toward) normal without destabilizing growth. That, right
now, is the key policy problem not whether the core PCE is going to climb three
tenths of a percentage point in the next two years….really! The Fed has been
framing this as a question of where r-star is. And in reality r-star (r*) is in
the Fed’s spot light more than the Fed’s two policy ‘targets.’ R-star is the
interest rate (natural rate of interest) that is neutral or stable-growth-low-inflation-preserving
at full resource utilization. Thus the question now is not whether inflation is
exactly at 2% but if there is some reasonable expectation, not a real true
forecast, but a reasonable expectation that it will rise there by 20XX as
growth progresses accordingly. Obviously
since inflation is ‘bit lean now’ the Fed could allow a slightly faster growth
rate and do this by keeping (rt
END
