“Boring” was how commentators on at least one network characterized the FOMC’s December 11th decision to hold rates constant.
It was, in fact, a no-brainer decision given the strong labor market, which created 266 thousand jobs in November; strong consumer spending based upon the Black Friday and Cyber Monday sales data; an unemployment rate at a historic low of 3.5%; and PCE inflation still below target. What was not boring, at least to those who are trying to divine where policy is likely to go, were several takeaways from Chairman Powell’s press conference and the Summary of Economic Projections.
First, Chairman Powell was clear that he and the Committee viewed policy – after the mid-cycle rate adjustments earlier this year – as well calibrated and in no need of further adjustments through 2020. Indeed, the Summary of Economic Projections (SEPs) for December were little changed from September. Median GDP growth remained at 2.2% for 2019 and 2% for 2020 through 2022. The unemployment forecast was lowered by .1 to .2 percentage points, reflecting a strong labor market, while headline PCE inflation forecasts were unchanged. The dot chart projected no rate movement in either direction for 2020 and then some upward movement in 2021 and 2022. One should be cautious, however, about putting much stock in the outlying rate projections, given the relatively poor track record of the SEP longer-run forecasts.
Second, there was much discussion at the press conference about labor markets and whether they were tight or whether considerable slack remains. Chairman Powell carefully explained that over time the Committee had continually adjusted its view of what constituted full employment and lowered its estimate of the natural rate of unemployment. He expressed the view that there still was some slack in the labor market, as evidenced by the lack of significant wage pressures or pass-through to inflation, along with a reversal in the decline in the participation rate. When pressed on what would cause the FOMC to begin to tighten policy, he simply replied “wages,” meaning that the critical metric was an abrupt acceleration in wages.
Third, the labor market and wage discussions were really intertwined with questions about the status of the FOMC’s ongoing review and reassessment of its policy framework, which Powell stated was likely to extend well into the middle of 2020 or thereafter. He pointed to the fact that, to be credible, the framework had to be more than just words. Here the FOMC has had a bit of a problem, in that it has mostly missed its 2% inflation target, except for a few months, since the target was officially established in 2012. How long can the FOMC go before the credibility of its target is truly undermined?
At root is the fact that policy makers need both reliable econometric models and an underlying framework for those models that can be easily explained to the public. For a long while, the Fed’s models worked reasonably well, and research showed that they performed at the high end when compared with private-sector forecasts. However, the same has not been true of the Phillips curve framework, which provided an easily understood way to describe the relationship between policy and the FOMC’s two primary goals of low inflation and full employment. According to the theory, inflation dynamics occurred in sectors where tight labor markets with low unemployment caused employers to raise wages to hire and keep employees, passing higher labor costs on to consumers in the form of higher prices. Interest rate increases, on the other hand, dampened demand, slowing the economy and taking pressure off wages and inflation. The framework also relied upon several key factors when the economy was in balance and at full employment. These include the so-called NAIRU, or nonaccelerating inflation rate of unemployment; the natural rate of unemployment (the lowest unemployment rate due only to structural and frictional causes); the potential rate of growth in the economy; and, more recently, the neutral rate of interest that is consistent with full employment and stable inflation. These concepts and the breakdown in what had, in the past, seemed a clear relationship between unemployment and inflation are at the heart of the FOMC’s policy framework review. Specifically, there are two critical problems which neither the FOMC or professional economists have been able to solve. First, at present there is virtually no exploitable tradeoff between unemployment and inflation. Powell argued in his press conference that the relationship still existed but was now very weak. Second, the ability to effectively calibrate policy in a forward-looking way hinges upon estimates of NAIRU, the natural rate of unemployment, and the neutral rate of interest. None of these concepts are actually observable either ex ante or ex post, yet must be estimated, and those estimates have proved to be unstable and variable over time.
In a world where the model framework has broken down and the key variables to that framework are at best fraught with estimation error, it has become difficult to calibrate policy with the kind of precision that seems to be demanded. And without a working model, there is not a convincing story to tell about what is being done and why. In this context, the FOMC’s framework review will be challenging, and we should not expect any big breakthroughs. We are left with the current state of policy, which is arguably still accommodative, for an economy growing at a rate in line with estimates of its potential, with a historically low unemployment rate and inflation still below target. In such a world, changing policy without a good, solid reason rooted in evidence is in itself a risky strategy. In this case, boring is good.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio
[1] See Jorda, Marti, Nechio and Tallman, “Inflation: Stress-Testing the Phillips Curve, FRBSF Economic Letter, February 11, 2019, https://www.frbsf.org/economic-research/publications/economic-letter/2019/february/inflation-stress-testing-phillips-curve/.
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