Weekly Economic Commentary by Scott J. Brown, Ph.D.
The Fed: Dual Targets Or Dueling Targets?
January 30 – February 10, 2012
The Federal Reserve has adopted an inflation target, as many other central banks have done long ago. However, the Fed retained its dual mandate, with a soft employment target. How will the two goals be achieved and what happens when they conflict? The Fed says is will use a balanced approach.
The Fed lengthened the period for which it expects to keep short-term interest rates at exceptionally low levels (now, “at least through late 2014”). However, the five Fed governors and 12 district bank presidents have differing opinions on when the Fed should start raising short-term interest rates and what the appropriate level of the federal funds rate target will be at the end of 2014. There was closer agreement on where the federal funds rate target is expected to be over the long run (a 2% inflation rate + a 2.0-to-2.5% premium = 4.0-4.5%)
The Fed will now shoot for a 2.0% annual rate in the PCE Price Index, which is similar to the CPI, but adjusts for changing patterns of consumption. The 2.0% goal would allow for more effective monetary policy during recessions. Other inflation-targeting central banks have a similar goal. For the Fed, a 2.0% inflation rate is “price stability.”
The Fed also is required to achieve maximum sustainable employment, which “stands on an equal footing with price stability as an objective of monetary policy,” according to Fed Chairman Bernanke. The unemployment rate statistic is an imperfect measure. It excludes discouraged workers and underemployment. Improvement over the last year has been exaggerated. Moreover, the unemployment rate consistent with maximum sustainable employment may change over time or may not be directly measureable. The Fed’s second goal is a judgment call, and opinions vary. Officials believe the appropriate unemployment rate target is currently between 5.2% and 6.0% – higher than it was before the financial crisis.
What happens when the Fed’s two goals conflict or when one goal is near its target and the other is far from it goal? Would a balanced response imply that a higher inflation rate is acceptable in the short run to help push the unemployment rate down? That’s possible, but it’s not what the Fed is currently forecasting.
The Inflation Outlook
January 23 – 27, 2012
The Consumer Price Index rose 3.0% in 2011 (December-to-December), twice the rate of 2010. A big part of that increase was food and energy prices, which picked up in the first half of the year. Ex-food & energy, the CPI rose 2.2%, not especially high. The shorter-term trend in the CPI is benign. The overall CPI fell at a 0.4% annual rate in the final three months of the year, while the core rose at a 1.8% pace.
Economists tend to focus on core inflation because we’re interested in the underlying trend – not because food and energy prices don’t matter. However, there are a variety of core inflation measures, including the median CPI, trimmed mean estimates, and my personal favorite, the stick price index (which measures inflation in prices that tend not to change very often). All of these measures rose in 2011, but from very low levels in 2010. The Fed’s chief inflation gauge is the core PCE Price Index, which, among these measures, fell the least in 2010 and rose the least in 2011. Recall that the PCE Price Index is similar to the CPI except that the weights shift as consumption patterns change over time (in the CPI, the weights are adjusted every five years). The PCE Price Index ex-food & energy rose 1.7% in the 12 months ending in November, which is smack in the middle of the Fed’s implicit comfort range of 1.5% to 2.0%.
When the Fed embarked on its second round of asset purchases in 2010, officials were worried about the threat of deflation. The 2011 inflation results suggest that the Fed was successful in warding off deflation, but inflation did not surge as some had feared. In 2010, Chairman Bernanke argued that real interest rates are what matter. For a given nominal interest rate, lower inflation raises the real interest rate – and higher real interest rates are less stimulative for the economy. One line of reasoning, not expressed by the Fed, but embraced by a number of private-sector economists, is that the Fed should shoot for a higher inflation target in the current environment, to push real interest rates even lower and further stimulate the economy. However, a short-term push for higher inflation could un-anchor inflation expectations. Nominal interest rates could rise, keeping real rates steady. More importantly, the Fed would risk losing its inflation-fighting credibility.
So where is inflation headed in 2012? The Fed views inflation as being driven by inflation expectations, which act as a form of inertia, and the amount of slack in the economy. Inflation expectations have remained relatively low. The spread between the 10-year TIPS yield and the regular 10-year Treasury yield has been trending at around 2.0% (this spread isn’t really the market’s expectation of inflation, but a rough approximation).
The economy is still operating with a large amount of slack. Inflation pressures could heat up if that slack were to disappear, but this should be a very gradual process. The labor market is the widest channel for inflation. In the oil price shocks of the 1970s and early 1980s, inflation quickly became embedded in the labor market. That hasn’t been the case more recently. Union membership was a lot higher in the 1970s and many unions had wage contracts tied to the Consumer Price Index. We’ve had a number of increases in oil prices over the last 10 years, but there’s been no sign that pressures have fed through to wages.
Higher oil prices, in recent years, tend to be associated with slower growth – a short-term burst of inflation, but not a higher inflation trend. Oil prices remain a significant wildcard for the growth outlook in 2012, but also for the inflation outlook.
Despite the moderate inflation results for 2011, some still believe the Fed’s accommodative policy will lead to a substantial increase in inflation sooner or later. However, we’re still a long way from a full economic recovery, and there will be plenty of time to unwind the Fed’s accommodation when appropriate.
Fed Policy Outlook – More Communication Is Good
January 16 – 20, 2012
The Federal Open Market meets next week to set monetary policy. It’s widely expected that short-term interest rates will remain unchanged and that (for the time being) there won’t be another round of asset purchases (QE3). The Fed will begin publishing the range of senior Fed officials’ projections of the appropriate federal funds rate target (for the fourth quarter of this year and the next few years). There are more benefits than risks in making these projections public.
After heating up in the first half of 2011, inflationary pressures have receded in recent months. Inflation expectations remain well-anchored and there is still a large amount of slack in the job market, which should severely limit any inflation pressure coming from labor.
U.S. economic growth is expected to be moderate in 2012, but there are continued headwinds and some downside risks. Europe remains the largest concern. Opinions about Europe vary, but the most common view is that the region will muddle along with a mild recession. It’s a bit of a game of chicken. Leaders are doing just enough to prevent a collapse, but not so much that Greece, Italy, and others can avoid making structural reforms. The European Central Bank continues to insist that it is not the lender of last resort. Yet, the ECB has also purchased Spanish and Italian bonds, pushing yields down and easing concerns that these countries won’t be able to roll over their existing debt. However, there is still some chance of a more dramatic deterioration in Europe. That decline would, in turn, have implications for Asia and emerging markets. The IMF is expected to lower its global economic outlook later this month. The risks to the outlook remain tilted to the downside.
A mild European recession would not have a major impact on the U.S. However, policymakers here would not be able to insulate the U.S from the impact of a more dramatic global slowdown. This outlook suggests that the Fed need not act just yet in response to Europe, but must be prepared to do more if conditions evolve in a less favorably manner.
Housing has been a major disappointment for the Fed. Officials thought that the housing recovery would be further along at this point. Residential homebuilding itself is a relatively small part of the overall economy – roughly 4% of GDP in normal times, 6% of GDP during the boom, and roughly 2% recently. However, depressed home prices have a negative impact on consumer spending. More importantly for the Fed, the weak housing market is mucking up the transmission mechanism for monetary policy. The Fed has helped engineer record lows in mortgage rates, but housing hasn’t caught fire. The Fed’s recent white paper on housing was another effort to get Congress to provide more support for the housing market. However, loan modifications and other proposed efforts are likely to only provide a mild lift to housing. These options, even if taken all together, would not be expected to turn the housing market around dramatically, but every little bit helps.
With a low inflation outlook and a continued high level of slack, the Fed has the scope to do more. A number of Fed officials have spoken in the last few months about the possibility of another round of asset purchases, centered in mortgage-backed securities. The minutes of the December 13 policy meeting showed that “a number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the committee's longer-run economic goals and policy framework.” We will have such enhanced communications at this policy meeting.
The Fed will now publish projections of the federal funds target rate and provide qualitative guidance on the Fed’s balance sheet. In addition, the Fed will provide a narrative describing the key factors underlying those assessments. Releasing the federal funds target rate projections of senior Fed officials brings some risks. There’s some chance that financial markets might misinterpret these projections as a hard commitment, with some potential loss of credibility if the Fed has to chance course later on. There’s a risk of the financial markets over-reacting to minor changes in the Fed’s outlook. However, there are more perceived benefits for the Fed. Given a range of projections (high, low, and central tendency), policy would be seen as not being the will of a single individual, but more correctly, as a group decision. Published projections of the federal funds target rate should enhance the continuity and coherence of monetary policy and encourage broader support for prevailing policies. The Fed has a lot to learn about how this will work in practice (granted, not much of this matters now that short-term rates are expected to remain unchanged for a long time).
In the past, the Fed has often used vagueness as a policy tool. For example, officials may have been at times uncertain of whether to raise or lower short-term interest rates. The Fed could hint of policy changes and let the bond market do the heavy lifting, and then if the policy move proved unwarranted, the Fed could hold off. Former Fed Chairman Greenspan was adept at this, although communications improved significantly under his stewardship. The Bernanke Fed set an early goal of even greater communication. The markets haven’t always heard correctly what Bernanke has said and increased public debate among senior Fed officials hasn’t always been helpful (adding to market volatility). However, more communication is better.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
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