Must-Read: Gavyn Davies: The Fed’s Lowflation Dilemma

Must-Read: The Federal Funds rate is currently bouncing around between 0.82 and 0.91%. When the Federal Reserve embarked on its tightening cycle in December 2015, its median expectation was that by now it would have raised the Federal Funds rate to between 2.25 and 2.50%—that it would have undertaken 9 25 basis point interest rate hikes rather than three. Its expectation was that, even after those nine hikes, PCE core inflation would be running at 1.9% per year rather than the 1.5% per year that the smart money currently sees.

A policy significantly looser than they thought they were embarking on. And inflation outcomes noticeably worse, in the sense of falling below target, than they anticipated even with the tighter policies they thought they would adopt.

Yet I have very little sense of how the Federal Reserve is adjusting its thinking to its forecasting overoptimism for 2016 and now for 2017. Nor do I have any great sense of how the Federal Reserve is dealing with the fact that it has now been overoptimistic in forecasting 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, and 2008:

Gavyn Davies: The Fed’s Lowflation Dilemma: “The [last] two months together have left core CPI inflation 0.4 percentage points lower than expected…

…When the PCE deflator is released next Tuesday, it will probably show the 12-month core inflation rate at 1.5 per cent in April, the lowest figure since the end of 2015…. The Fed’s decisions are supposed to be data dependent…. The Fulcrum inflation models… produce short term projections for inflation based on methods that extract underlying price increases from noisy monthly data. The models’ near term inflation projections (red line) have dropped sharply as a result of the March and April CPI announcements, and the inflation rate for the rest of 2017 is now projected to run well below the rates forecast by the Fed in March (blue dots)….

Where does that leave the FOMC? I agree with Tim Duy that their present stance is still biased towards gradual tightening, because they are not yet placing much weight on changes in data methodology, or in the Phillips Curve. They have now dug themselves into a position where they will be extremely reluctant to drop the intended 25 basis points increase in the fed funds rate on 14 June, or the start of balance sheet shrinkage, probably announced in September. Lowflation will probably be less evident in coming months. Only if that fails to happen will monetary policy normalisation be placed on hold.

The Fed s lowflation dilemma Https www federalreserve gov monetarypolicy files fomcprojtabl20151216 pdf Https www federalreserve gov monetarypolicy files fomcprojtabl20151216 pdf

May 28, 2017


Brad DeLong
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