The Daily Update - The Quandary on Inflation

In recent congressional testimony, Chair Janet Yellen expressed dismay that inflation has remained persistently below the Fed’s target of 2% despite years of monetary stimulus and a decline in jobless claims to its lowest level in more than 40 years. This recent shortfall in US inflation seems strikingly ‘abnormal’ relative to that of recent years, especially in the context of a tighter domestic labor market and comes at an awkward time as the Fed has set course for an historic unwinding of its extraordinary policies of the past eight years. Will low inflation derail the Fed’s exit strategy? If not, where are they headed?

Notwithstanding the fascination of market observers with the quandary presented by the latest undershooting, the Fed is not likely to give up on the notion that inflation will begin to rise now that the economy has reached its potential – at least not yet. One of the most enduring relationships in macroeconomics has been the link between the so-called output gap and inflation. But it is worth noting the delayed response of core inflation even after real GDP exceeds its inflation-stable potential. This seemingly perverse lag can be seen during the late 1990s and again in 2003 when inflation actually declined after output had already surpassed potential. On average, the delayed reactions can last for one year, so this latest undershoot is not yet cause for FOMC members to lose faith in this relationship.

The Fed should be concerned, however, about the strength of this relationship. Fluctuations in inflation seem to have narrowed sharply over the past 30 years even though real GDP has continued to overshoot and undershoot its optimal full-employment level by as much as ever. Globalization of production and supply chains coupled with rapid technology transfer and outsourcing of services undoubtedly have played a major role in weakening the link between inflation and domestic output. Whatever the cause, the Fed no longer presume that monetary stimulus alone will generate either a quick or pronounced response on the inflation front. The story on wages is similar, namely, tight labor markets no longer make much difference when employers set their pay scales.

The efficacy of any monetary policy strategy depends critically on the transmission mechanism from interest rates and credit creation to output and inflation. In an ideal world, there would be a direct path from the Fed’s policy rate to the end goals of stable inflation and full employment. Unfortunately, that path has become riddled with diversions and detours that are weakening the effectiveness of monetary policy initiatives. Troubled banks do not necessarily lend more because their cost of funding from the central bank is low or even zero; even when credit is readily available and inexpensive, households and businesses do not necessarily rush to borrow more money (only governments seems to do so); too much borrowing is devoted to unproductive activities that do not raise potential GDP but rather are squandered on mergers, acquisitions and real estate development that hollow out existing structures; and now the transmission from output to inflation has diminished to the point where monetary stimulus has become less potent.

An implication is that the extraordinary policies including asset purchases and negative real interest rates have little redeeming value at full employment. They now are no longer contributing to the efficacy of monetary policy, and indeed were never intended to be permanent fixtures on the monetary landscape but rather a temporary expedient to stabilize a global financial system in crisis. At the center of the maelstrom were global banks with too much leverage, sketchy derivative products and unknown counterparty risks. Now all major US banks have passed stress tests that give the Fed some comfort that the financial can stay afloat without the aid of a life support. Absent immediate concerns about the safety and soundness of the financial system, the FOMC has charted a course to unwind both its bloated balance sheet and negative interest rates.

Another implication of shifting economic parameters is that the Fed will need to change its milestones for effective monetary policy. The old norms no longer are valid. Of greatest uncertainties for financial markets are 1) the neutral policy rate; 2) the ultimate target for the size of the Fed’s balance sheet; 3) the rate at which the Fed will approach those new metrics; and 4) the economy’s potential growth rate. On the neutral rate, FOMC participants are moving slowly but inexorably toward a real rate of zero to ½ percent, notwithstanding a higher range implicit in their ‘dot’ forecasts for the policy rate. Since most Board members also are projecting growth in excess of its potential, their forecasts for the policy rate should exceed the new neutral rate, which implies that at some point policy actually would become tight and the yield curve may invert. Staff studies support a new neutral in the range of zero to 1%.

Some FOMC members including Lael Brainard and John Williamson place greater emphasis on unwinding the balance sheet rather than reaching the new neutral rate, so as to have less impact on the US dollar. That reasoning seems plausible but presumes carry trades exploiting interest rate differentials would dominate all else, which may prove unlikely if other central banks follow the Fed’s lead in normalizing policy as the Bank of England and Bank of Canada already are doing. The ECB may too be close behind.

The ultimate target for the size of the balance sheet has not yet been decided. Estimates range from $2.5 trillion to $4.2 trillion. The lower number seems sufficient to manage Fed operations; the latter seems excessive. At the runoff rates already announced, the balance sheet will reach a new mid-range norm of $3.2 trillion by the end of 2021. The market impact of such a gradual withdrawal by the Fed would be almost imperceptible – an increase of about 15 basis points annually on the 10-year Treasury bond yield. Similarly, the federal funds rate already is almost halfway to the new neutral, and at the current rate would reach that norm by the end of 2018. These glide paths are so shallow that they have elicited characterizations as ‘boring’ and akin to ‘watching paint dry’. In Europe and Japan, the exit will prove to be much more difficult and testing for financial markets, especially now that the US economy has reached that unique tipping point at which output has reached is sustainable potential and hence policy blunders – either monetary or fiscal - have serious long term consequences. If the US economy’s sustainable growth rate has slowed to less than 2% as most evidence indicates, then the Fed and almost everyone else are destined for some major disappointments.