Beckner: FOMC To Reassess Outlook, Review Monetary Policy Framework

26 January 2018

26th January 2018

By Steven K. Beckner

- Will Trump Policies Change the Fed's Policy Assumptions? - Is It Time To Modify the Inflation Targeting Regime?   The Federal Reserve's upcoming Federal Open Market Committee meeting -- the last at which Janet Yellen will officiate before handing the gavel to Jerome Powell-- will be unusual. This is not just the first meeting of the year, it is the last of an era, not just because Powell and a whole new cast of characters are arriving, but because the U.S. economy seems to have been launched on an a new course -- one that could force a rethinking of Fed assumptions. Don't expect anything dramatic at this Jan. 30-31 interlude (or interregnum if you like). It's highly unlikely any monetary policy decisions will be made in the strict sense. The FOMC just raised the federal funds rate last month for the fifth time since leaving the zero lower bound two years earlier. And balance sheet reduction is proceeding "on auto pilot" -- steadily shrinking the Fed's massive securities portfolio through attrition. The FOMC won't have to produce a new Summary of Economic Projections (SEP), including a funds rate "dot plot," until its March 20-21 meeting. So it has the luxury of not having to make tough policy decisions. But that doesn't render it a non-event, for two reasons: First, it's a time for Fed policymakers, many of whom will be sticking around and two of whom will vote for the first time, to take stock of rapidly changing economic, financial and fiscal conditions and discuss whether December's forecasts and projections still make sense, or whether they need to be reassessed. Second, although it doesn't have to change rates, the FOMC is scheduled to review and potentially change its Statement of Longer-run Goals and Monetary Policy Strategy -- the so-called monetary policy "framework."   Reappraising The Economy Policymakers have to wonder whether something radically new is going on that needs to be confronted in coming months. Consider: - 3%-plus real GDP growth (although fourth quarter GDP growth was provisionally reported at a less than expected 2.6%, but final sales to domestic purchasers grew 4.3%); - synchronized global expansion; - the unemployment rate stands at a 17-year low 4.1%, and initial jobless claims are at their lowest level in 45 years; - all-time low African-American unemployment; - faster wage gains, and in wake of a $1.5 trillion tax cut, Walmart and others are lifting minimum wages and paying bonuses; - surging business investment, highlighted by Apple's recent $350 billion capital spending announcement; - the Dow Jones Industrial Average recently cleared 26,000, its seventh 1,000-point milestone in a year; - the yield curve is steepening, with the 10-year Treasury note yield now above 2.6%; - signs of rising inflation and inflation expectations. And so forth. You get the picture. Of course, the other side of the Wall Street bull market is its vulnerability to correction. Former Council of Economic Advisors Chairman Martin Feldstein, who blames stocks' run-up on excessively easy Fed policies, warns they are headed for "a steep drop." But I don't detect any willingness among policymakers to pull their monetary punches to prevent a downturn. Notwithstanding political brinksmanship over illegal immigration, fundamentals seem sound. Pullbacks are seen as buying opportunities. (Even during the brief government shutdown, major stock gauges posted gains!) In compiling their December forecasts and projections, FOMC participants considered the potential impact of tax cuts, but many were reluctant to accept exuberant predictions from the White House. Now that tax reform and deregulation are yielding real rewards, officials may want to reconsider. The FOMC faces a new reality: It's just possible these tax cuts will rejuvenate the economy like the Reagan and Kennedy cuts. They may not only stimulate demand but exert positive supply side effects on hiring, investment and productivity. Officials have to at least allow for that possibility. Their reassessments could lead to significant upward revisions in the March SEP. Of course policymakers can't just assume the best. Cleveland Federal Reserve Bank President Loretta Mester exemplified the likely approach Jan. 18: "If the economy evolves as I anticipate, I believe further increases in interest rates will be appropriate this year and next year, at a pace similar to last year's," i.e. three 25 basis point rate hikes. "This gradual upward path of interest rates will help balance the risks and prolong the expansion so that our longer-run goals of price stability and maximum employment are met and maintained," said Mester. "This policy path gives inflation time to move back to goal while, at the same time, avoiding a build-up of risks to macroeconomic stability that could arise if the economy is allowed to overheat, with the Fed then having to raise rates sharply in response. It helps avoid a build-up of risks to financial stability should overly low interest rates encourage investors to take on excessively risky investments in a search for yield." But the Fed must be ready to take a less gradual approach, if necessary, Mester implied. "We will need to calibrate our policy decisions to how the economy actually evolves and the implications of incoming information for the medium-run outlook and risks around the outlook." Some reassessment is already underway. Dallas Fed President Robert Kaplan, who last summer was being "patient" until he saw "more evidence" inflation was headed toward 2% and who thought the pace of rate hikes might have to be "slower," now sounds different. He voted for the December rate hike and recently suggested the FOMC might have to raise the funds rate more than three times this year. Mester has been emphatic that four hikes will probably be needed. San Francisco Fed President John Williams, once considered a "dove," has made similar comments. It remains to be seen how two new voting presidents will lean, although Atlanta's Raphael Bostic sounded cautious on Jan. 8. Though this looks like "a strong year," he was "not projecting that 2018 will be a breakout year for growth." He alluded to "a puzzling lack of wage and price pressure," though he was "somewhat encouraged that the last couple of inflation reports." Bostic was "comfortable continuing with a slow removal of policy accommodation," but cautioned "that that doesn't necessarily mean as many as three or four moves per year.... (T)he current stance of monetary policy is still somewhat accommodative but is approaching a more neutral stance." And, he added, "it is important to remember that the Fed is also removing accommodation by shrinking its balance sheet." Obviously the FOMC doesn't have to decide the number of 2018 rate hikes on Jan. 31, but a consensus on appropriate policy gets built over time, a process that will continue at the upcoming meeting. Changing the Monetary Framework?                                                       Even as the locus of monetary conversation shifts from concern about inflation undershooting toward concern about overheating, past undershooting of the 2% inflation target has generated much talk of changing the monetary "framework." One of the FOMC's tasks at this meeting will be to review its "longer-run goals and monetary policy strategy." As first stated in January 2012, the FOMC judged that "inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances." That statement has been reaffirmed almost automatically every January. The only significant change came in 2016, when the FOMC amended it to call its inflation target "symmetric" and added it "would be concerned if inflation were running persistently above or below this objective." Might the FOMC amend it further this year? Probably not, but there's been a lot of talk about making changes, and these are sure to be discussed. Even though the latest wage and price data point upward, there is plenty of residual concern about sub par inflation. Chicago Fed President Charles Evans, who dissented against the December rate hike, reiterated his concern Jan. 17. Even those who are more comfortable about inflation may be willing to support a different approach to targeting for the future. In the minds of some, concern about low inflation dovetails with concern about a perceived decline in the real equilibrium short-term interest rate and in turn the nominal neutral funds rate. If the longer term funds rate is 2.8% (0.8% real plus 2% inflation), as the FOMC estimated in December, that doesn't leave much room to cut rates to counter recession. So some officials want to rethink the policy framework. Potential alternatives include: - raising the inflation target to, say, 3%, which would in turn raise the neutral rate and hypothetically give the Fed more room to ease if necessary. The Fed would still base policy on year-over-year changes in the inflation rate and basically forget about last year's inflation rate. - price level targeting, in which the Fed would focus not on the inflation rate in any given year but seek to make up for shortfalls in inflation in prior years. It would target a path for the price level and allow inflation to rise faster, if needed, to get the price level back up to that path. - nominal GDP (or nominal income) targeting, where again the Fed would not target the yearly inflation rate but target the path of nominal GDP (real growth plus inflation) and make up for past shortfalls. - temporary price level targeting, a hybrid "make-up" approach in which the Fed would target the inflation rate during "normal" times, but resort to price level targeting when the funds rate falls near the zero lower bound. Former Fed Chairman Ben Bernanke set the stage for discussion of a new framework last October when he proposed a temporary price level target, to apply only when rates fall toward the zero lower bound. Under his strategy, the Fed would delay liftoff from the zero until the average inflation over the entire contractionary period has reached 2% and full employment is restored. Bernanke said permitting temporary overshooting of the inflation target to make up for previous undershooting would let the Fed "calibrate the vigor of the policy response...to the severity of the episode." Then vice chairman Stanley Fischer said Bernanke's idea "seems to make some sense." Governor Lael Brainard said it "has the advantage of maintaining standard practice in normal times while proposing a makeup policy in periods when the policy rate is limited by the lower bound and inflation is below target." Evans spoke favorably of what he calls "state-contingent price-level targeting." Bernanke's proposal did not get universal praise. Brainard cited risks.   "The public, seeing elevated rates of inflation, may start to doubt that the central bank is still serious about its inflation target...," she cautioned. "A related risk is that the central bank would lose its nerve. Maintaining the interest rate at zero in the face of a strong economy and inflation notably above its target would place a central bank in uncomfortable territory." She also questioned how the Fed would get back to its standard policy rule without "a relatively sharp path of tightening." The proposal sparked considerable discussion in ensuing months. Minutes of the December meeting disclosed, "Due to the persistent shortfall of inflation from the Committee's 2 percent objective, or the risk that monetary policy could again become constrained by the zero lower bound, a few participants suggested that further study of potential alternative frameworks for the conduct of monetary policy such as price-level targeting or nominal GDP targeting could be useful". Since December there has been a flurry of official ruminations. Praising price level targeting, St. Louis Fed President James Bullard said "deviations from target are overcome by allowing for higher or lower inflation in the future in such a way that the inflation target is maintained on average. In contrast, today's inflation targeting regime simply allows misses and does not do anything about them." Boston Fed President Eric Rosengren opined "we should be focused on an inflation range, with the potential to move within the range as the optimal inflation rate changes." He said "there are several compelling arguments for a more robust periodic review of the Federal Reserve's monetary policy framework." "My own personal preference would be to conduct a full review with a specified frequency -- possibly longer than the five years used by the Bank of Canada -- but to make it possible to call for an earlier review when warranted," Rosengren said. "Given the unpredictability of changes in the optimal targets, providing the option to call for a special review would be important. This would allow for a re-examination when needed -- specifically when most participants view economic events as justifying a full re-examination of the framework." Mester said "we will need to evaluate whether the net benefits of any of the alternatives would outweigh those of the flexible inflation-targeting framework currently in use in the U.S. and in many other countries." Mester said price-level and nominal GDP targeting "have the benefit of building in some forward commitment, which is useful at the zero lower bound," but observed "there is little international experience with such frameworks to assess how they would work in practice." And there are other problems, she warned. "For frameworks targeting levels instead of growth rates, the starting point matters, and these frameworks are complicated by other measurement issues as well...... (B)ecause the level-targeting frameworks do not let bygones-be-bygones, data revisions pose a more serious issue than they do with inflation targeting..." Then too, "explaining this unfamiliar framework to the public could be difficult," noted Mester, adding, "One also has to ask whether it is a credible commitment on the part of policymakers to keep interest rates low to make up for past shortfalls even when demand is growing strongly or to act to bring inflation down in the face of a supply shock by tightening policy even in the face of weak demand." All this commotion seems a bit ironic at a time when growth is accelerating, labor markets are tightening and inflation may finally reach or exceed 2%. It could be alleged some are fighting the last war. Even so, the FOMC could decide to give itself more flexibility for the future.   -------------------------------------------------- Steven Beckner is a veteran financial journalist with four decades of experience of reporting on the Federal Reserve.  Mr Beckner is the author of Back From The Brink: The Greenspan Years (Wiley, 1997) and can also be heard speaking regularly on National Public Radio.