Fed Fight!

October 13th, 2015 at 6:36 pm

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.

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3 comments in reply to "Fed Fight!"

  1. Amateur says:

    It is psychological. The urge to raise rates is psychological.

    Anyone that has risen to preside over this institution must believe in it, and they must therefore believe that it must act. In what way? It must act! It must make changes!

    I would ask them if they’re comfortable with the possibility that raising rates in the next 10 years might be harmful. Perhaps 10 more years.

    Does that make them uncomfortable? Why?

  2. Tom_in_MN says:

    The neutral rate is almost twice the current 10 year rate? Does anyone really believe that? They keep predicting the 10 year rate will go up and so far there is no sign of it.

  3. Peter K. says:

    This is good to hear coming out of the FOMC. Yes Congress is broken, but I was encouraged by the Democratic Primary debate last night. People seemed fired up. As Sanders said people need to get involved in order to save the middle class and the country. [See the Fed Up! teach ins.] Otherwise you have apathy and low voter turnout rates.

    I wish the candidates would talk about a full employment economy with rising wages. They sort of did that.