December FOMC: Diluting the Fiscal Punch Bowl

14 Dec 2016

Today’s decision by the FOMC to raise the target range for the federal funds rate by 25 basis points was widely anticipated by markets. A slightly hawkish Summary of Economic Projections, however, was not. Most significantly, the median FOMC participant’s projection for appropriate policy now suggests three rate hikes next year. I had viewed a slight steepening of the projected rate path as a risk going into the meeting. This was because the unemployment rate has recently fallen below the Committee’s median estimate of NAIRU. Thus keeping inflation stable around two percent over the forecast horizon should require a slightly tighter policy stance. This is indeed the view that the Committee appears to have adopted. The median Committee participant now projects that policy will be at a roughly neutral setting by the end of 2019, earlier than projected in September. What I had not anticipated, however, was that some Committee participants have already begun to incorporate fiscal stimulus into their projections. A few participants had commented before the blackout period that it seemed too early to incorporate fiscal stimulus into modal projections for growth and monetary policy. It would appear that not all participants took this approach;  Yellen herself stressed her own uncertainty over the fiscal policy outlook, but noted that a few members had begun to reflect their expectations for stimulus in their macroeconomic and policy projections.

Incorporating fiscal stimulus at this point in modal policy expectations strikes me as premature, given the complications associated with trying to pass substantial corporate and individual tax reform without a filibuster-proof Senate majority. And while today’s adjustments to the SEP were fairly small, they should serve as a warning shot to investors that the Committee has little intention of sitting on the sidelines and keeping policy accommodative in the presence of fiscal stimulus when the economy is already at or very close to full employment. While doing her best to avoid weighing in on specific fiscal measures during her press briefing, the Chair was nonetheless quite clear that from a cyclical perspective the economy does not require fiscal stimulus and that the Committee would certainly take fiscal stimulus into account when setting policy.

For the time being, I am retaining my call for two policy rate increases next year. This is because I believe the Committee will ultimately tolerate a modest inflation overshoot given concern about returning to the lower bound. In addition, I anticipate that financial conditions will continue to tighten in the coming months, particularly in the form of higher long-term rates and a stronger dollar, and this should restrain growth and inflation.  Pro-growth tax policies may also be somewhat slow to materialize given the sheer scope of what Republicans are trying to achieve on tax reform. Still, the risks to my monetary policy outlook are to the upside. Progress on fiscal reform, and plans for modest increases to military and infrastructure spending, could take shape relatively quickly, invigorating animal spirits and pulling forward household consumption and business investment (and hiring) even before legislation is enacted. Prospects for broad deregulation across a number of sectors may also boost household and business confidence, with positive implications for growth.

Finally, there has been an ongoing debate in markets about the significance of Chair Yellen’s comment at a research conference in the fall on the potential benefits of running a “high pressure economy”. I admit to having been somewhat puzzled by her comment – at first blush I saw it largely as the Chair raising an important research topic. But at the same time I wondered if she was laying the groundwork for an inflation overshoot in the years ahead, and beginning a politically savvy communications campaign aimed at portraying an overshoot as a way of boosting employment. Today, Yellen removed all doubt and stated where she stands on this topic – she was in no way endorsing such a strategy, and was instead raising the issue solely to encourage research. Still, we should distinguish between running a “high pressure economy” and tolerating a modest inflation overshoot. The former suggests a sustained period of above-target inflation in order to achieve particular policy goals such as raising trend growth and boosting employment. The latter involves treating the inflation objective symmetrically, possibly to ensure that the public does not view the two percent objective as a ceiling, or due to risk management concerns such as proximity to the lower bound and uncertainty about the neutral policy rate. As I noted above, I continue to believe that the Committee will eventually tolerate an inflation overshoot. But their communications on this topic have been inconsistent at best – submissions to the SEP show very little tolerance for inflation above two percent in the years to come. Today’s communications reveal much the same, and risk undoing some of the very positive rise in market-based measures of inflation compensation seen since the election.