Fed should hug you with alligator arms

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 (r_t

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