In advance of the Fed’s announcement on rates tomorrow…

December 13th, 2016 at 5:24 pm

The Fed started its December meeting today, one in which they are highly likely to decide it’s time for another rate hike. Prediction markets are posting a 95 percent probability that the Fed lifts their benchmark interest rate tomorrow from a target range of 0.25-0.50 basis points (hundredths of a percent) to 0.50-0.75. I’m confident that prediction is correct.

So, whassup with that?

Why now?

Why is the Fed likely to raise in this versus prior meetings? What’s changed? A lot, actually.

While the Fed is thankfully somewhat insulated from politics, they have to stay on top of interactions between politics, fiscal policy, markets, and growth. The so-called Trump rally—the DJIA is up almost 9 percent since Nov 8—is built on the notion that a business-friendly president whose cabinet is “stocked” with bankers and billionaires will oversee more upward redistribution of growth, along with financial market deregulation.

[The fact that such policies have, in the past, exacerbated inequality and inflated bubbles is clearly not…um…the focus of markets right now. Sometimes I think the fatal flaw of humans reduces to our unwillingness to give a crap about the future (inequality, recession, melting icecaps) when we can have something today. But I digress…]

Operationally, the Trump rally reflects his plan for a big, regressive tax cut (also infrastructure investment, though see below). Inflation and interest rates have firmed significantly since his election, based on the expectation that he’ll inject a serious slug of stimulus into an economy which is already nudging towards full employment.

Also, as the jobless rate has fallen, wage growth has accelerated, from around 2 to 2.5 percent, on average. The price of a barrel of oil is also up 15 percent (almost $8) over the past month.

All of this has bumped up inflationary expectations, if not core (sans oil, food) inflation itself. The figure below shows two series of market-derived inflation expectations, both of which turn up pretty sharply towards the end (before the election, but the daily measures show a spike afterwards). There’s the “5-year, 5-year forward inflation expectation rate,” which captures expected inflation over a five-year period that begins five years from now. It’s just above 2 percent (the Fed’s target rate), meaning investors expect inflation to average a little over 2 percent between December of 2021 and December of 2026. The 10-year TIPS breakeven rate reflects similar expectations. (This rate is the difference between the yield on bonds that include an inflation risk premium and those on inflation protected bonds; once you “net out” the latter, what’s left over is inflation expectations.)

Source: FRED

Source: FRED

The thing is, no one knows what president-elect Trump and the Congress will actually pull off. My guess is that these expectations are directionally correct but overblown. There will be a big tax cut, but perhaps not as big as the markets are pricing in. A serious infrastructure dive may also be a bigger question mark than many investors seem to think (Trump’s original idea is limited and not well constructed [sic]).

But it doesn’t matter what I think. What matters is what the Fed makes of these expectations. More precisely, it’s the extent to which such movements signal to a majority on the FOMC (the group that votes on the rate hike) that anchoring inflationary expectations requires a hike. Based on that standard, I can certainly see where they’d react to the recent upturns with tomorrow’s predicted increase

But is a rate hike warranted?

What hasn’t changed much is the actual, underlying rate of core, PCE inflation, the Fed’s preferred benchmark. As you see in the next figure, excepting a few months in early 2012, it’s undershot the Fed’s 2 percent target for eight years! Moreover, it’s generally agreed that the target is an average, not a ceiling, so having been below it for so long, there’s room to run above it for a while.

Source: BEA

Source: BEA

In fact, it’s essential that we do so. Even grizzled full employment warriors like myself agree we’re getting close to that long-awaited condition, though underemployment rates and prime-age employment rates are still too high/low, points on which Chair Yellen has been consistently clear. Moreover, the low jobless rate is finally delivering some long-missing bargaining clout to middle- and lower-wage workers, and the last thing those workers need is to fight against the headwinds of higher interest rates.

But isn’t their wage growth bleeding into price growth? Not at all. My colleague Ben Spielberg made the following scatterplots. The first one shows yr/yr inflation (PCE core again) against nominal wage growth for blue collar workers in factories and non-managers in services, about 80 percent of the workforce over the full length of the series, which starts back in the mid-1960s.

Sources: BLS, BEA

Sources: BLS, BEA

While wage and price growth correlate over the life of the full series, over the current expansion (gray dots) the correlation goes the wrong way. But, you say, this has been a uniquely weak expansion with wage growth for these workers coming late in the game. OK, I say back, let’s look at the strong 1990s recovery (salmon dots; i.e., Ben tells me they’re “salmon”; I’m color blind and even if I weren’t, I wouldn’t use salmon dots), where full employment eventually drove solid real wage gains across the pay scale. Same thing—the correlation again goes the wrong way.

I should mention, non-incidentally, that we got to full employment in the 1990s because Alan Greenspan ignored those telling him that the unemployment rate was falling too far below what was erroneously believed to be the “natural rate” of 6 percent.

OK, perhaps I’ve convinced you on the wage-growth-not-driving-inflation part of the story (there’s academic evidence for this too). But just because you don’t see wage pass-through to prices doesn’t mean that full-resource utilization, as proxied by low unemployment, won’t drive up inflation. Then why hasn’t the inflation line accelerated in the PCE figure above? Yes, the scatterplot below shows low inflation at high unemployment, but it also shows low inflation at low unemployment.

Sources: BEA, BLS

Sources: BEA, BLS

Look, the Fed’s almost sure to raise tomorrow, and frankly, at this point, I think the volatility induced by surprising markets would be an own-goal kick that the Fed should probably avoid. But I don’t trust these recent blip-ups in markets and expectations based on the notion that Trump and his merry band of billionaires are going to be great for investors. And even if they are, a) the Fed may push back the other way by raising rates more quickly, and b) unless unemployment stays very low, none of these goodies are trickling down to workers.

I don’t mean to slight the incoming econ team; they deserve a chance and they’re certainly inheriting a different economy than the one faced by the team I was on 8 years ago.

But my priors suggest that the Fed may be the only rational, fact-based economists at the controls for a while…maybe a good, long while. They need to block out the noise, remain in data-driven mode, and allow the recovery to continue reaching those who’ve only recently begun to benefit from it.

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6 comments in reply to "In advance of the Fed’s announcement on rates tomorrow…"

  1. Adam says:

    I am no economic policy expert, not really even a neophyte, but it always surprises me how few levers and metrics the Fed has to work with in monetary poloicy. My opinion is that a low interest rate has highly favored asset investment over business and job investment, contributing to a job market where there’s been a sluggish and fairly unglamorous recovery, while helping along commercial and residential real estate markets much more quickly.

  2. Smith says:

    Were you aware of Roger Farmer’s work arguing the Phillips Curve and Natural Rate (of Employment) Hypothesis are not supported by data?

    While I consider the Phillips Curve, Taylor Rule, and NAIRU mostly useless when they’re not actually destructive, I come at the question of employment vs inflation from a different angle than Farmer.

    Current theory is supposed to be that wages climb pushing prices causing inflation which the Fed counters by raising interest rates slowing business activity causing unemployment removing pressure for more wage hikes.

    My contention is that businesses raise prices to counter any gains from labor and that causes inflation. There are a whole host of reasons for how and why this happens, but most obviously they do it because they can.

    Of course we all know (except for Janet Yellen) that nominal wages may rise equal to the inflation rate plus productivity increase with no inflationary effect. For the last quarter (3Q July – Sep) productivity was measured moving up at a 3.1% rate and labor costs at .7%

    In the end, you can not get labor better wages if you slow the economy in response to rising wages. To the extent that higher wages cause higher prices, they only do because of businesses behaving badly. You can increase competition with anti-trust enforcement, and regulate natural monopolies and both (in the case of the newly merged Time Warner Cable), create greater transparency of prices, use government purchasing power, restore previous price controls (and please a federal usury law at no more than 15%, to prevent debt bubbles of higher inflation). The 2% average inflation target is still lunacy, for the millionth time, inflation at or below 2% and unemployment below 5% when the economy was not in a recession occurred only four times in the past sixty years, 1998, 1965, 1955, 1954. But if automakers, big retailers, banks, healthcare providers, just raise prices to counter any wage increase, they need to be stopped, and not with higher interest rates. You don’t destroy the economy to save it.

    Galbraith wrote about this in the early 1970s before stagflation. He wrote about it in the 1950s too.

    Wages are not high and real wage gains of recent are merely after effects of oil price drop still rippling through economy, hence low inflation rate.

    • Jared Bernstein says:

      Yep, re Farmer. He makes a strong case. BTW, Yellen has explicitly made the point you make above, re non-inflationary wage growth = prod + inf target. I’ve added an ‘x’ factor that!:

    • Smith says:

      Here is Larry Summers echoing my call on increased monopoly power (but from March of this year)

      But my larger point is that the same power to push profits is the same power to cancel rising wages and create premature cost push inflation. Since 2007, no one has had to worry about this. Wages weren’t exactly booming in the naughts either, so there’s been no need for this concern since the 1990s when Greenspan let things hum. But really in the late 90s the oil prices collapsed (partly due to Asian crisis) letting everyone off the hook.
      Please notice where inflation was except for the oil gift year, no below 2%.

      There needs to be a war on 2% for now. Maybe back in the 1960s that worked. The trouble with 2% comes from business raising prices. Even if a war is waged on price increases (yes, a two front war), the economy needs slack of higher inflation so labor doesn’t wait for perfect conditions to keep pressuring for increases. Until business learns that labor won’t accept wage increases passed on to consumers, raising inflation, negating real gains, inflation must be allowed to rise.

      • Smith says:

        Stiglitz also rails against the increasing anti-competitive nature of the economy (here from May 2016)

        However, this is used to explain rising inequality. What seems obvious is that the same power to extract profits also allows price hikes in a full employment economy and creates cost push spiraling inflation, absent Fed intervention. The Fed for historical reasons, has a hair trigger to prevent this, as they assume there are competitive markets with prices rising in reaction to costs, but constrained by those supposedly aforementioned competitive markets. Meanwhile liberal economists argue over a tuning of the Phillips curve, Taylor Rule, and NAIRU, as if picking the right inflation target, unemployment level, and interest rates are all that’s required. Even Farmer’s dismissal of the NRH (natural rate of unemployment hypothesis and uselessness of Phillips Curve) doesn’t address the question.

        Galbraith addressed the questions fifty years ago (inflation vs. unemployment), and repeatedly. Noting this in the early 1970s, the power of oligopolies to raise prices at will, his solution was a totally planned economy, nationalized industry, with price controls. This seemed and still seems excessive, unnecessary, inefficient, unworkable, and constraining. But of course the government already does curb and control prices directly for traditional natural monopolies, like energy and communications, and through medicare and medicaid, restrains healthcare costs to a healthy degree. Banks before 1978 were told how much interest they could charge (15% max since colonial times), although now typically high rates, up to 30% would make Shylock blush. So comparing Galbraith’s and what I deem more workable solutions are a matter of degree, not principal.

        The point here is there are many ways to constrain prices, which include direct control, regulatory, and by statute, and absence of competition is just one area that needs attention. Yet even liberal economists, even those addressing increasing anti-competitive nature of business today, ignore the implications for warping the tension between unemployment and inflation. Instead the main tool of using the bludgeon of interest rates is accepted, destroy the economy to save it.

        I’m not saying lack of competition is the only reason for pricing independence, or price insularity, (is there a better or accepted term for this?). Neither is increased competition the only solution. But I strongly question why interest rates (and thereby unemployment) seem to be accepted as the main tool for constraining prices, even by liberal economists.

  3. dwb says:

    The fiscal stimulus will not be nearly as large as people are expecting. There will be a tax cut, but I strongly doubt either Trump or the GOP will tolerate large deficits. I think we will get some version of the so-called penny plan to reduce spending as well (penny plan = hold flat nominal discretionary spending, or reduce it or 1% each year until the budget is balanced). I am going to go out on a limb and forecast that Trump and the GOP will apply this to non-discretionary spending too.

    Since 1980, The Fed raising rates has preceded a recession 5/6 times. That is because they were looking to disinflate the economy. In 2007 they misread the economy and the 2008 meeting minutes show they were more worried about commodity price inflation than uneployment. Let’s not forget, Sept 2008 as Lehman and AIG were collapsing the Fed funds rate was still at 2%, only to be cut a few weeks later. They may not have caused the recession, but they certainly made it a lot worse with their peevish focus on non-existent inflation.

    This time is different, or not. Unemployment of 4.x% does not tell the tale. How long has Japan been caught in a sub-par equilibrium with low unemployment? 30 years? Official unemployment is not capturing discouraged workers.

    My preferred measure of unemployment is U-6 or the prime age 25-54 employment-population ratio. The 90s felt good because the prime age EP ratio was 80%, peaking at 82%. Right now it’s 78%. We have a very long way to go, 60 months at least. The Fed should let the EP ratio get back to 81% or so. That will only happen if they let the economy go.

    My personal view is that Trump is 100% unafraid to inject politics into Fed policy. The FOMC is one mistake away from losing it’s independence. That could come though the GOP forcing rules-based policy, or Trump taking scalps. I don’t like it, but then again, I don’t like that the Fed has overpredicted growth for 8 years either and been too peevishly focused on non-existent inflation.

    Tightening too early would be exactly that mistake.