The September FOMC Meeting: A Litmus Test on Normalization Tactics

19 Sep 2016

Through the recent twists and turns of recent Federal Reserve communications and economic data, our baseline expectations for near-term policy have not changed. We believe that the FOMC will hold off on raising rates when it meets this week. There is nothing in the data to suggest an urgency to resume policy normalization. Inflation remains below the Committee’s year-end projection, the early indicators on economic activity in August have been disappointing, and a tightening presidential election may increasingly exert some drag on the economy, including through financial market volatility.  Beyond the near-term outlook for the economy, a number of Committee participants have noted other factors that in our opinion argue for continued patience. These include the challenges associated with providing additional stimulus near the zero lower bound should the economy falter, uncertainty about the current level and likely path of the neutral policy rate, and uncertainty about the non-accelerating inflation rate of unemployment, or NAIRU. Indeed, some labor market indicators such as the broader U6 unemployment rate suggest remaining slack in the labor market.

While the Committee is unlikely to resume policy normalization this week, we expect signaling  of a probable rate increase at the December meeting via projections for the year-end policy rate, changes to the statement language, and Yellen’s press conference. This signaling will likely be balanced by a flatter projected rate path in the years ahead. With projections now extending an additional year, we expect a 2.4 percent reading for the median 2019 projection, still below the Committee’s median projection for the longer-run policy rate (which we do not expect to change).

Still, we do not have a high degree of confidence in our base case, and assign a relatively high 35 percent probability to the Committee moving forward with a rate increase this week. This is because at the end of the day, the Committee remains wedded to its normalization strategy of gradually raising the policy rate to a neutral level by the time that core PCE inflation reaches two percent. And in a very broad sense, the economy is moving in line with the Committee’s projections. Even if growth has been disappointing, labor market slack continues to diminish, and the current level of core PCE inflation is just a tenth below Committee participants’ median projection for the end of the year.

These reasons for our inherent uncertainty of the meeting outcome are what make this meeting so important. If the Committee moves ahead and raises rates, it will have revealed that normalization tactics have not changed. So long as the Committee has some reasonable confidence in its projections being realized, it will continue to raise rates going forward. As we have written elsewhere, we would prefer a strategy shift in which the Committee waits for inflation to rise to two percent before raising rates. This would make clear that the Committee is treating its inflation objective symmetrically.  Barring such a strategy change (which we admit is highly unlikely), a tactical shift that awaits full confirmation in the data that economic projections have been achieved would be preferable. In our view, continuing with the tactic of raising rates based on confidence in projections, as opposed to realization of these projections, risks tightening policy too aggressively. This is a sub-optimal approach when a return to the zero bound could require extremely aggressive (and possibly not credible) use of forward guidance and a doubling of the Federal Reserve’s balance, as Yellen pointed out at Jackson Hole.

Even if the approach of putting relatively more weight on projections instead of outcomes does not derail the economy, it could limit inflation pressures and increase the odds that over the next several years PCE inflation will continue to average under two percent. This would be an important signal to markets, as it suggests that two percent is not an inflation objective, but rather a ceiling.  Indeed, we think that many investors already believe that the Committee’s normalization strategy implies that inflation will be managed with a two percent ceiling in mind. The Summary of Economic Projections continually signals much the same; for several years now, almost no Committee participants have expected inflation to rise above two percent over the projection horizon.

In summary, this meeting is an important litmus test. Raising rates now would reveal that inflation and labor market activity broadly consistent with projections is a sufficient condition for raising rates, now and in the future. Holding off on a rate increase instead suggests that the Committee increasingly prefers to see confirmation that its projections are being achieved. We see the merits in the latter approach, given the asymmetry of available policy responses at the zero lower bound and inflation that has persisted for years below the objective. In fact we do not see some future overshooting of the inflation objective as very costly at all, and indeed it can have benefits. It would communicate to the public that the Committee treats its inflation objective symmetrically, and would also provide ammunition to lower real interest rates in the next recession.

Some Final Comments on the Summary of Economic Projections

We have written elsewhere about potential improvements to the Summary of Economic Projections. In particular, we have advocated that the Committee publish “fan charts” for the policy rate and the balance sheet which show the inherent uncertainty around members’ policy projections. We now have a second suggestion in mind. Committee participants have increasingly referenced a low but time-variant neutral policy rate as an important factor in policy deliberations. Unfortunately, there is little agreement on how to measure the neutral policy rate, and we suspect that Committee participants have a wide range of estimates of its current and future level. To better understand the Committee’s thinking on the policy outlook, the public would benefit if Committee participants included in the quarterly projections their estimates for the current level of the neutral rate, and for each year of the projection horizon. Projecting the path of the neutral rate is no doubt challenging. But if the Committee has sufficient confidence to publish projections of the longer-run neutral federal funds rate (as it currently does), it should have at least equal confidence in projecting the neutral rate’s current level and path to its longer-run value.