“[T]he concept of monetary policy in the United States at its core involves crucial elements of risk management.” Former Federal Reserve Chairman Alan Greenspan, Remarks at Jackson Hole, August 29, 2003.
Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose by 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.
With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.
We start with a look at the data. The following chart plots our two favorite gauges of core inflation: the trimmed means of the CPI and the chained PCE price index. These statistical measures remove the components of the price index that rose and dropped the most. The solid lines show average inflation for the previous five years. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable.
U.S. Consumer Price Inflation, 12-month percent change, 1998- 2018
Why is inflation so stable? One explanation is the rise of global economic integration. Over the past quarter century, trade in goods and services (as measured by imports plus exports worldwide) has increased from roughly 40 percent of global GDP to more than 60 percent. At the same time, gross cross-border investment positions rose from 50 percent of GDP to more than 150 percent. This globalization of markets for goods, services and capital has come along with a rise in the importance of a common global factor affecting inflation (see Ciccarelli and Mojon). In the 1990s, for example, fewer than 40 percent of countries (in a sample of 146) had inflation that was positively correlated with the average (GDP-weighted) global inflation. Today that number is nearly 90 percent (see next chart). In other words, the common factor is more significant, and this applies to the United States as well.
Histogram of correlations of country inflation with global inflation, 1980-1995 and 1995-2015
The following chart—showing annual inflation for the euro area, Japan, the United States, and the 39 countries the IMF classifies as “advanced”—largely confirms the pattern. As in the United States, consumer price inflation in the advanced economies has fluctuated around 2 percent, averaging 1¾ since 1995. And, consistent with the globalization hypothesis, inflation in these countries—which account for 60 percent of global GDP at market prices—generally has moved together. While these stylized facts also appear consistent with the rise of inflation-targeting regimes across the leading economies, we suspect that increased economic and financial integration has helped to limit the potential for significant deviations from the global norm, even for a country as large as the United States.
Annual Consumer Price Inflation for the Advanced Economies, 1995 to 2017
This all brings us to monetary policy and the Federal Open Market Committee. For the past year and a half, the Committee has been tightening policy at a steady pace. Since January 2016, they have raised the target range for the federal funds rate on six occasions by a total of 150 basis points so that it now stands at 1.75 percent to 2.0 percent. And, since October 2017 the Fed’s balance sheet has been slowly shrinking. Furthermore, following the most recent meeting, the FOMC dropped the projection of persistently lower-than-normal interest rates, replacing it with guidance that rates will continue to rise. Nevertheless, monetary policy remains accommodative from a long-run perspective. That is, the policy rate is clearly below any sort of neutral rate.
To see how far below, consider the FOMC participants’ own estimates of what one might call the equilibrium federal funds rate. The following picture combines information from every survey of economic projections (SEP) since the canvass began in 2012. With each SEP, the Fed reveals the participants’ forecasts for the “longer run.” We plot the range and the median of these longer-run projections.
Range and median of FOMC members’ “longer-run” interest rate projections, 2012-Jun 2018
Since the inflation objective is fixed at 2 percent, we can use these nominal interest rate forecasts to infer the FOMC members’ estimate of the decline in the neutral real interest rate (also called r*). In early 2012, their estimate of r* was in the range of 1.75 to 2.50 percent. Today, six years later, the range has fallen to between 0.25 and 1.50 percent. The implication is that all FOMC participants believe policy will be accommodative so long as the nominal federal funds target rate is below 2¼ percent, and some think it would still be accommodative until the target reached 3½ percent.
That is the background: policy remains accommodative with inflation stable and slightly below target, and with unemployment falling further below 4 percent. By highlighting that economic growth is now solid, the FOMC is aware that inflation could begin to rise faster than anticipated. Should that happen, interest rates might have to go up markedly more and faster than currently believed.
While we have raised doubts about the usefulness of a Phillips curve for policy analysis, it would be foolish to ignore many signs of a tight (and still-tightening) labor market. The unemployment rate could soon sink below 3½ percent, something that has not happened since the 1950s. And, there is more than one job opening per unemployed person, something that has not happened since the Bureau of Labor Statistics began collecting these data in 2000. (The previous high was 0.9 in early 2001.)
In addition, the short-run outlook is for strong growth that sharply exceeds any estimate of the economy’s long-run trend. The Federal Reserve Bank of Atlanta’s “nowcast” shows the U.S. economy expanding at a phenomenal 4.8 percent annualized rate in the current (April to June 2018) quarter. And, various forecasts suggest that the mix of federal tax cuts and spending increases could add as much as a full percentage point to growth over the coming year, even if these do little to boost sustainable growth.
Before moving on, we should say a word about the fiscal stimulus itself. In their recently concluded annual assessment of the U.S. economy (known as the Article IV consultation), the IMF noted the extremely procyclical nature of the tax cut, estimating that the country has a structural deficit of about 1½ percent of GDP when output already exceeds the sustainable trend by roughly 2 percent. The last time something like this happened was in the 1960s when a “guns-and-butter” fiscal policy financed both the Vietnam War and the “Great Society” programs. The Fed’s policy failure at the time helped usher in the Great Inflation.
Both theory and experience suggest that the current debt-financed fiscal expansion should drive interest rates up and crowd out some private investment. So far, the market response has been fairly muted. And policymakers’ response even more so: the FOMC participants’ projections for the longer-run federal funds rate made in September and those published last week are nearly the same.
We suspect that the FOMC is engaged in what Alan Greenspan called “risk management” policy. For example, they now refer frequently to the “symmetric” nature of their inflation objective. We assume this means that they are willing to allow inflation to overshoot for a while. How much and for how long? No one can be sure. However, using the FOMC’s preferred price index and starting at the beginning of 2011, prices today are about 2½ percentage points lower than they would be had they achieved their 2-percent-target continuously. (Starting further back, say in 2007, the price-level shortfall is nearly twice that size.) Allowing inflation to rise to 3 percent for a few years would close this gap. It also would provide policymakers with greater scope for cutting the expected real interest rate should a recession hit, say, in 2020, well after this expansion has become the longest on record (the record is now only a year away).
Several years ago, we argued that the FOMC should be cautious about tightening policy for a variety of reasons. We noted that the estimates of the neutral rate had fallen, that the economy’s productive capacity could be endogenous, and that there is a critical policy asymmetry when the nominal interest rate is near the effective lower bound―the point where conventional interest rate policy becomes useless as a means to counter deflation risks.
The first of these concerns remains compelling: while fiscal policy may begin to push it higher, the neutral rate has surely fallen compared to five or 10 years ago. The worry about policy asymmetry is no less powerful: the scope for raising interest rates should inflation rise above target is far greater than the scope to lower them in a recession. Yet, It is easy to see why the FOMC now wishes to pick up the pace of normalization: near-term growth is likely to continue to outstrip the trend significantly at a time when there appears to be little slack in the economy. Adding in an adverse supply shock from developing trade frictions certainly won’t help.
Bottom line: the FOMC is still managing risks, but some risks have shifted.