Monetary Policy Outlook: The United States (Fall 2017)

What Will (Probably) Happen?

What the Federal Reserve thinks:
- that the U.S. economy is near full employment…
- that U.S. potential-output growth rate is 2%/year…
- that it should be “normalizing” interest rates…
A positive shock to growth (or inflation) will see the Fed raise faster and further:
- Do not expect real growth much above 2%/year under this Fed…
- Do expect the Federal Funds rate to rise at about (3/4%/year)/year—or faster—as long as the economy can stand it without recession…
- A negative shock to inflation will see slowed but not stopped “normalization”…
A negative shock to growth will see:
- The Federal Reserve quickly return the Federal Funds rate to zero…
- And then dither, with many tools but none of them powerful to affect the economy…

Employment-to-Population, 25-54

I think the Fed could be more aggressive at promoting growth…
Prime-age employment-to-population numbers in the U.S. still show considerable labor market slack…
But the unemployment rate shows over-full employment…
Wage growth shows no labor supply-side pricing power for workers…
Yet the Federal Reserve trusts the unemployment rate much more than other indicators…
- This creates a puzzle because…

Inflation Remains Subdued

Back in the 1950s Alan Greenspan declared that 2%/year measured inflation was “effective price stability”…
The Bernanke-Yellen Federal Reserve decided to use the core PCE chain index…
Persistent undershoot:
- Since January 2009, cumulating to 4%-points in the price level…
- Recent price news not suggesting any inflationary spiral developing soon…
Suggesting that the tightening cycle announced in mid-2013 and begun in 2016 was premature…
- The market agrees with me…

The Long Nominal Rate, Inflation Breakeven, and Long Real Rate

When Larry Summers was Deputy Treasury Secretary, he convinced Bob Rubin to issue TIPS…
- We now have 15 years of watching the long nominal rate, long real rate, and the difference between them:
  - The expectations based inflation breakeven…
- These give us a better window…

Secular Stagnation

Fall in (notional) TIPS from 4% at end of 1990s to 2% in mid-2000s…
Fall in TIPS from 2.0–2.5% pre-crisis to 0.0-0.5% today…
Without any signs of a runaway boom of any sort…
- But increased appetite for debt…
- Any risks being generated?

Implications for the Fed-Controlled Short Rate and the Long Rate

The Federal Reserve controls the interest rate on Treasury bills…
- Subject to the condition that it cannot drive it below zero (without making substantial institutional changes in the banking system)…
The long rate goes where it wants…
- And it has not wanted to go up for a long time indeed…
- Expect a lot of time at the zero lower bound over the next decade…

Might We Get a Different Fed?

Summing Up

Implications for Trading Partners

U.S. not a locomotive for demand…
U.S. not a (major) source of likely upward demand or upward interest rate shocks…
Trading partners have to decide how to react to the tightening cycle:
- But it will be slow (probably)…
- Hence (probably) innocuous…
Trading partners do have to worry about a recession in the United States:
- Given the absence of powerful monetary policy tools to the Fed’s hand…
- Given the lack of political will for non-monetary stimulus…