The Twitter-verse is abuzz with pretty overtly dissenting opinions coming out of the Federal Reserve right now. Chair Yellen and Vice-Chair Stan Fischer have leaned pretty hard into the view that rates should go up before the end of the year, while in the last couple of days, Fed governors Lael Brainard and Dan Tarullo (B&T) have said, “um…not so fast.”
As one dramatic headline put it: “Brainard and Tarullo reject Phillips Curve, and in doing so, Yellen and Fischer.”
Here at OTE, we’ve long maintained the correlation between slack and inflation (that’s the Phillips Curve) is both increasingly diminished and poorly understood. As such, B&T make a fair point that this traditional work horse is not the pony you’d want to bet on in terms of informing Fed policy.
But that much is pretty well known. What’s new here is Brainard’s extremely sensible discussion of risks faced by US monetary authorities right now. Here’s the key text, with my annotations in brackets:
I view the risks to the economic outlook as tilted to the downside.
[Other than the low unemployment rate, which is showing less slack than there really is due to some measurement shortcomings, the key indicators, most notably inflation, are weak. Add to that some weakening in international markets which have led to a stronger dollar and tighter financial conditions, and you get the ‘tilt’ she cites here.]
The downside risks make a strong case for continuing to carefully nurture the U.S. recovery– and argue against prematurely taking away the support that has been so critical to its vitality.
[This would be a particularly dangerous time to raise rates. Here’s why:]
These risks matter more than usual because the ability to provide additional accommodation if downside risks materialize is, in practice, more constrained than the ability to remove accommodation more rapidly if upside risks materialize.
[Boom. There’s the punchline. If the economy slows further, if the Fed keeps missing its inflation target on the downside—as has been the case now for a few years—there’s little-to-nothing they can do about it. Generating even more slack by raising rates—even a little—thus is playing with fire. “Progress toward full employment and 2 percent inflation would stall or reverse,” warns Brainard.
But if “upside risks materialize”—if inflation should significantly accelerate—the Fed’s got gobs of accommodation they could remove.]
The asymmetry in risk management stems from the combination of the likely low current level of the neutral real interest rate and the effective lower bound.
[The risks of slow growth, persistent slack, the zero-lower-bound, and dis-inflation are both greater and more threatening than the opposite risks. Interest rates are historically low, as Larry Summers likes to point out (this is part of his secular stagnation hypothesis) and have been for a while now in economies across the globe. The implication is that the neutral Fed funds rate—the interest rate consistent with full employment—is itself likely lower than its been in the past. Brainard points out that most of her Fed colleagues “…now forecast a level no higher than 3.62 percent–down from 4.12 percent in September 2012.”
That in turns implies that even in “equilibrium,” the Fed will be closer to the feared zero-lower-bound that’s limited monetary policy for years now.]
Good for B&T for their strong applications of common sense here, both as regards the non-performing Phillips Curve and the pretty starkly asymmetric risks. We should be very happy that we’ve got such thoughtful people in important places right now.
But before you get too happy, let me remind you of an implication of all this, one I haven’t seen Fed folks say much about lately: all this downside risk means there’s an important and salutary role that fiscal policy could be fulfilling right now (think investment in public infrastructure, for example). But that’s not going to happen, because Congress is broken.