Obsessing yet again about the Federal Reserve’s unnecessary current dilemma

I really am obsessing about this to excess, am I not?

But it’s overwhelmingly weird: conclusions that seem to me obvious and inescapable, nailed-down and air-tight, ironclad and titanium do not seem to have any force with the deciding members of the FOMC:

Paul Krugman: Fed Fumble: “US growth seems to have slowed sharply…

…Given the combination of slowing growth and a big deterioration of financial conditions, there’s growing talk that the Fed made an error in hiking rates. Oh, and market compensation for future inflation, which may not be a good indicator of expectations but surely contains some information, has plunged. It might still turn out OK. But it might not, and surely everyone would be feeling more comfortable if the Fed had waited, and probably decided not to hike for a while. Still, who could have seen this coming? Um, Larry Summers; me; Brad DeLong; basically everyone who thought about the asymmetry of risks. We didn’t know that the data would come in weaker than expected, but we knew that they might, and that it would be much harder to respond to a downside shock than positive news.

So why didn’t the Fed see it that way? I have never gotten a clear answer…

Krugman’s conclusion:

It really seems as if management somehow got set on the notion that it was time to raise rates–I think because, consciously or not, they wanted to throw Wall Street and the GOP a bone–and got into a loop of incestuous amplification in which the clear precautionary case against a hike got excluded from the room.

Not just a clear precautionary case: an overwhelming precautionary case given uncertainty about the location and slope of the Phillips Curve in addition to uncertainty about the trajectory of global and U.S. demand.

Cf: Nick Bunker:

Nick Bunker: Context may be everything when it comes to the Phillips curve: “The slope of the Phillips curve has declined…

..inflation will increase less for a given decrease in the unemployment rate. At the same time, inflation expectations have become, in economics-speak, incredibly ‘well-anchored.’ Investors believe quite strongly that U.S. inflation will stay around 2 percent…. Wage growth actually doesn’t pass through that much to inflation anymore…. Given the declining share of income going to labor and the high share of income going to profits, perhaps we shouldn’t be surprised that wage increases aren’t filtering on to accelerating inflation. The economic situation has changed quite a bit. Stronger wage growth today may do more to increase the labor share of income than spark inflation.

Context may be everything when it comes to the Phillips curve Equitable Growth

Cf: Robin Wigglesworth:

Robin Wigglesworth: Talk of Fed ‘Policy Error’ Grows: “Even fund managers who were sanguine about December rate rise are now more unnerved…

…‘It is reasonable for investors to wonder whether Fed’s December rate hike was a policy error,’ admits Bob Michele, chief investment officer of JPMorgan Asset Management. ‘Historically the Fed has raised rates because either growth or inflation was uncomfortably high. This time is different — growth is slow; wage growth is limited; deflation is being imported.’… Most economists maintain the risk of a US recession this year are slim, but markets are now pricing roughly even odds of one, and that in itself has consequences. As Larry Fink, the head of BlackRock, said last week, the ferocity of the stock market rout ‘puts a negativity across the economy, a negativity to every CEO looking at his or her stock price, a negativity about business’. Should financial turbulence infect the real economy, the US central bank’s plan to raise rates another four times this year becomes extremely challenging. Investors have long doubted this rate path, but now they are virtually laughing at it…

But what happens next?

Tim Duy has views:

Tim Duy: The Five Scenarios Now Facing the Federal Reserve: “I see five likely scenarios…

…(1) The economy slips into recession, and the December rate hike is yet another in a long line of central banks’ failed efforts to pull up from the zero-bound. (2) Financial market conditions stabilize… limit(ing) the Fed to just one or two more rate hikes later in the year…. (3) The Fed’s baseline scenario in which it hikes rates in four 25-basis-point increments this year…. (4) Inflation begins to accelerate. This would push the Fed toward more than 100 basis points in rate hikes this year. (5) Financial markets remain choppy in the first half of the year, pushing the Fed into ‘risk management’ mode…. Officials’ delayed response calms markets and prevents a slowdown in activity, but they feel behind the curve and try to catch up with a steeper pace of hikes late in the year.

Financial market participants at the moment are likely caught somewhere between the first two scenarios. Scenario five, however, requires serious consideration (and would currently be difficult to differentiate from the first two)…

The asymmetry of risks inescapably leads to the conclusion that you only want to start raising interest rates when you are pretty sure that you will see the whites of inflation’s eyes in two years. The flatness of the slope of the Phillips Curve in recent Phillips Curve data, the low pass-through of past inflation to current expectations in recent Phillips Curve data, and the large residual variance that has always been found in estimated Phillips Curves together make it impossible to conclude that we are pretty sure that we will see the whites of inflation’s eyes in two years.

Very sharp observers report that their conversations with current FOMC staff go along the lines of: “Well, you need a forecast to make policy, and you need a model to make a forecast, and this is the model we have got.” And I concur that that is what they are thinking: that is what I hear too. But you don’t need to use a model with expectational and employment-pressure gearing that is two decades out of date when you know that those coefficient have stochastic drift over time. You don’t need to use a model that puts a weight of one on the unemployment rate and zero on the employment-to-population ratio when there is no evidence-based way to separate out the two to assess the proper weighted average. And you don’t need to make policy using only the expected model path paying no attention to the asymmetric risks, the asymmetric loss, and the wide fan of possible future states of the world. “This is the model we have got” is simply not an answer at any appropriate level…

January 28, 2016


Brad DeLong
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