Tim Duy: What Is the Fed Going to Do?

Writing from the land of tall fir trees, mandatory Pendleton wool shirts, and constant rain, the thoughtful Tim Duy notes that neither he nor the markets believe what the Federal Reserve is currently saying

Tim Duy: On Challenging the Fed: “Bond yields… breach[ed] the three percent mark at the end of last week. Mortgage rates have been pulled along… the sustainability of the housing recovery will again be questioned…. This very much looks like a challenge to the Federal Reserve’s forward guidance….

What is somewhat remarkable about higher short-term rates is that at their December meeting the Fed lowered the expected path of interest rates…. The Fed and the market are moving in different directions…. What has changed to make markets doubt the Fed?… Consider that the low rate story was driven by a combination of faith in the optimal control framework championed by incoming Federal Reserve Chair Janet Yellen and the belief that the decline in the unemployment rate was overstating the improvement in the labor market… [but] Ben Bernanke threw cold water on both ideas in his final press conference….

CHAIRMAN BERNANKE. Well, again, these are individual estimates, there are big standard errors implicitly around them and so on. We do think that inflation will gradually move back to 2 percent, and we allow for the possibility, as you know, in our guidance that it could go as high as 2½ percent. Even though inflation has been quite low in 2013, let me give you the case for why inflation might rise…

After explaining why the Fed expects inflation to move higher, Bernanke adds:

CHAIRMAN BERNANKE. Well, even under optimal control, it would take a while for inflation—inflation is quite—can be quite inertial. It can take quite a time to move. And the responsiveness of inflation to increasing economic activity is quite low…. But we are, again, committed to doing what’s necessary to get inflation back to target over the next couple of years.

In other words: “Don’t believe all those nice little charts Yellen has been touting that show inflation smoothly rising above two percent. We are not trying to recreate those charts, so don’t expect us to maintain accommodation even if inflation is below two percent. And, by the way, we aren’t really trying to drive inflation above two percent, we are just making clear that we will not panic if inflation is up to 50bp above target. Moreover, a symmetric target also means that we will not panic if inflation is 50bp below target, and it is easy to see how we get to that minimum level.”  

I don’t really believe they will not panic if inflation crosses two percent. I think that, given the size of the balance sheet, they will panic. In my mind, the decision to taper only reinforces my belief that the Fed is more comfortable with inflation below two percent than above it. The target is not symmetric…

I think that Tim Duy is accurately characterizing what the continuation of a Bernanke Fed would do. But I think it is likely–and here is one of the very few small differences between a Bernanke and a Yellen Fed–that a Yellen Fed will not panic until inflation gets above not 2%/year but 3%/year. Remember: Janet Yellen believes in her models, and believes in optimal control. This is a woman who–to the great surprise of the Clinton administration types like me who pushed for her original appointment to the Fed in the 1990s–went into inflation-hawk opposition to Alan Greenspan’s “let the tech boom rip and see how far we can go” policies of the late 1990s.

As I model her views, they were that the structure of the economy was unlikely to have shifted fast enough between the late-1980s and the late-1990s to make Greenspan’s policies the best ones from an optimal-control framework. And, I believe, she relied on that judgment even though she is, at some deep level, Ms. Labor-Force-Upgrading-in-a-High-Pressure-Economy and thus inclined to be a tad dovey-dovey on inflation,

And she has experience in watching how a Fed Chair–like Alan Greenspan–can keep inflation hawks from shifting policy prematurely, before sufficient data is in.

Thus my guess is that Bernanke in his final press conference went beyond his proper brief: there is enormous continuity in policy between the Bernanke and the Yellen Feds, but his remarks seem to me to have focused on one area in which there may well be a distinct difference.