Some Post-Tapering Announcement Observations
In one sense, the Federal Reserve’s tapering announcement last week is no big deal: the Fed will continue its massive quantitative easing (QE), and cutting back asset purchases by $10 billion per month is tiny relative to $2.5
trillion outstanding in excess bank reserves already created through QE (the Fed has emphasized the importance of stocks rather than flows); moreover, the Fed will continue to anchor its target policy rate to zero.
In another sense, the Fed’s announcement is significant, insofar as it begins the process of an eventual normalization of monetary policy following five years of unprecedented monetary stimulus. Through its forward guidance and its economic and interest rate forecasts, the Fed plans on an elongated adjustment period.
During this period, many of the key assertions underlying the Fed’s unconventional monetary policy will be tested. My hunch is that not everything will unfold as planned and there will be some bumps and surprises. One cannot expect the Fed’s turbo-charged monetary stimulus—appropriate for “crisis management” but sustained for years after the financial crisis ended and well into economic expansion—not to have dramatic lagged effects. The Fed has purposely ignored or downplayed the lagged impacts of its policies.
In its Policy Statement released last week, the Fed emphasized that it will not hike rates until well after the unemployment rate falls below 6.5 percent and until the Fed forecasts inflation to rise back to its long-run objective of 2 percent. At the same time, the Fed maintained its forecast of stronger real GDP growth, and lowered its forecasts of the unemployment rate and inflation.
Most strikingly, the Federal Open Market Committee’s (FOMC) median forecast of the “appropriate” target federal funds rate at year-end 2016 is 1.75 percent, at the same time the committee projects the unemployment rate to be 5.2-5.8 percent and inflation between 1.7-2.0 percent.
Maintaining a negative real funds rate in the eighth year following the financial crisis when the economy and labor markets are back to potential would be inadvisable and risky. Typically, real rates rise and fall over economic cycles, and normal monetary policy involves a positive real Federal funds rate when the economy is operating close to potential. Why does the Fed consider it appropriate to maintain an accommodative monetary policy three years from now, when it forecasts that it will have achieved its dual mandate of full employment and 2 percent inflation?
The Fed only rarely maintains a negative real funds rate, and amid the current maturing economic expansion, it is unique. Such monetary policy is associated with or it generates high inflation (the mid- and late-1970s), and it generates significant distortions or misallocations of resources (the housing bubble of the 2000s) that adversely affect economic performance. And every episode of negative real funds rates subsequently has been followed by a rise in the Fed’s policy rate target significantly above inflation.
The Fed has argued that more and more monetary stimulus is a remedy to the high unemployment rate that is cyclical in nature, resulting from insufficient demand, and that the slack in labor markets and the economy (that is, the GDP Gap is very wide and the unemployment rate is way above estimates of the NAIRU) virtually guarantees that future inflation will not be a problem.
But it has seemed clear that to date the lackluster economic response to the Fed’s unprecedentedly aggressive monetary stimulus has resulted from a host of non-monetary factors that have constrained domestic demand, production and employment. These economic drags are real—such as adjustments from the financial and housing crisis—and some stem from misguided fiscal and regulatory policies. They cannot be remedied by more liquidity and excess bank reserves. Two observations seem obvious.
First, some of these economic drags—household balance sheet adjustment and deleveraging, the housing and mortgage sectors, declining government consumption and purchases, and extreme risk-adverse behavior by businesses, partly in response to anti-growth government policies and related uncertainties—have either reversed (housing) or are toward conclusion. As the headwinds diminish, the Fed’s extreme monetary stimulus will now generate stronger growth that will build momentum.
Second, the underperformance of labor markets—slow employment gains, the decline in the labor force participation rate and employment-to-population ratio and downward pressure on wages for many workers—are to some extent structural. They are not all cyclical as the Fed contends.
In recent months, consumer spending, production and employment have all strengthened. Also, for the first time in years, global growth is picking up, led by the large industrialized nations, which should boost U.S. exports. Nominal GDP, the broadest measure of aggregate demand and production, grew at a 6.2 percent annualized in 2013Q3 and private forecasters are revising up their outlooks for 2013Q4 and 2014. Even based on the modest growth pickup forecast by the Fed, year-over-year nominal growth will reach approximately 4.5 percent by 2014Q2.
In the near term, most of the rise in nominal spending will be real. In Q3, real GDP rose 4.2 percent annualized. Typically, inflation approaches the extent to which nominal growth exceeds potential. Recently, nominal GDP has grown a weak 3-3.25 percent—no wonder inflation has drifted down toward 1 percent. Stronger nominal growth means stronger product demand that will provide businesses flexibility to raise prices—and will also raise the demand for labor and exert upward pressure on wages. An acceleration of nominal GDP above 5 percent—a highly likely lagged outcome of the Fed’s stimulus—eventually would generate inflation above comfort levels.
But what if the Fed has overstated its assessment that virtually all of the high unemployment is cyclical? That in reality, skill mismatches, demographics and a variety of government policies are reducing the available supply of qualified labor? If so, the stronger demand for labor associated with a pickup in growth would exceed qualified supply and generate bottlenecks in production processes. Inflation would rise before the Fed’s slack-driven models predict, and eventually rise higher. And the wage gap between skilled and nonqualified workers would widen further.
How would the Fed respond to such an unanticipated outcome? Historically, the Fed has responded by re-estimating its GDP Gap and NAIRU models to make its inflation models fit, and adjusted monetary policy with a lag. But its actual response is difficult to anticipate. Congress may not be happy with labor market trends, and no doubt other factors will play into Fed deliberations.
The Fed has been understating the lagged effects of its unconventional monetary stimulus and presumes that the return to normalcy can take place ever-so-gradually through 2017. My strong hunch is the Fed will not have such luxury, and the Fed’s policies and forward guidance set the stage for a potentially rocky road to policy normalization.
Mickey D. Levy is a member of the Shadow Open Market Committee