Former Federal Reserve chairman Alan Greenspan, in year nine of a US economic expansion, conceded in 1999 that patience was sometimes a better policy than his doctrine of preemptive interest-rate moves because “the future at times can be too opaque to penetrate.”
For some Fed officials, these days look like one of those times to wait for clarity.
Faith in preemption – the Greenspan-era strategy of setting of monetary policy based on forecasts to get ahead of where the economy was going – is beginning to falter among some officials. That’s because in the current expansion’s ninth year, inflation isn’t accelerating as they predicted for reasons that aren’t yet understood, even as the labour market tightens and global growth improves.
“The conventional wisdom did not work in the 1990s and it is not working now,” said Allen Sinai, chief executive officer of Decision Economics in New York.
The debate over whether the Fed should get ahead of the inflation curve or stick with a wait-and-see approach is heating up ahead of the Federal Open Market Committee’s meeting next week. Influential policy makers such as governor Lael Brainard and New York Fed president William Dudley have staked out different views about whether to let the job market run hotter or rely on once-trusted models and cool it down preemptively.
Officials are expected to keep rates on hold while announcing the start of a gradual process to shrink their $4.5tn balance sheet. Still, the discussion about why inflation has been stuck under their 2% target for most of the past five years could sharpen between hawks pushing for another hike this year and doves preferring to delay. Outsize declines in the prices of things like cell phone plans, doctor visits, new vehicles and hotel rooms have contributed to a broader deceleration in US inflation over the past five months despite low US unemployment.
That has led key policy makers not only to question whether the labour market still has more room to run before triggering excessive inflation, but also whether they should still be taking a preemptive approach to warding it off at all – a view at the core of modern central banking. The coming months should be revealing, according to Dudley, who said on September 7 that technology-enabled changes in how consumers shop may be weakening business pricing power and weighing on inflation.
“We just don’t know at this point whether the inflation decline that we’ve seen is mostly being driven by transient, idiosyncratic factors, or whether it’s something more secular, longer-term at play,” Dudley said. “My view is the jury’s out, and I think the data over the next six months is going to be very, very important.”
Either way, the New York Fed chief believes officials should still be able to count on the so-called Phillips curve – named for the late economist William Phillips, whose 1958 discovery of a historical relationship between unemployment and wage growth in the UK guided generations of central bankers.
To Dudley’s mind, the question is whether structural changes have led to a situation in which inflation is lower for any given level of labour utilisation. If so, it would imply that the Fed can delay further rate hikes until unemployment falls further, but that it will eventually need to resume preemptive tightening to ward off inflation as it rises toward 2%.
“I’m not ready to throw the Phillips curve out the window, but I am willing to be a little bit agnostic about whether full employment is potentially as high as we think it is,” he said.
Brainard has less faith that inflation will eventually rise back to the target if the unemployment rate goes low enough. Part of the doubt is due to low inflation expectations, which may represent the underlying, trend level of inflation.
“Some might determine that preemptive tightening is appropriate on the grounds that monetary policy operates with long lags, and inflation will inevitably accelerate as the labor market continues to tighten because of the Phillips curve,” she said on September 5. “However, in today’s economy, there are reasons to worry that the Phillips curve will not prove very reliable in boosting inflation as resource utilisation tightens.”
Prospects for fiscal stimulus after Republicans won the US presidential election in November appeared to raise expectations for inflation among investors, but the effect has faded over the past six months amid a return to political gridlock in Washington.
“The key question in my mind is how to achieve an improvement in longer-run inflation expectations to a level that will allow us to achieve our inflation objective,” Brainard said. “I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time.” A year ago, when concerns about global growth loomed over financial markets, there was more discussion among policy makers about allowing inflation to rise above their 2% target. That may be a tougher sell today, said Neil Dutta, head of US economics at Renaissance Macro in New York.
“It seems as though the rest of the committee sees weak inflation as being largely a function of factors unlikely to persist,” Dutta said. “With financial markets in a healthier place today than a year ago, a shift to more of an explicit overshoot seems less likely.”
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