The Federal Open Market Committee has a problem. Throughout this tightening cycle, it has battled against the perception that it does not treat its 2% inflation objective symmetrically. The Committee made some progress in changing this narrative in early 2018, when core inflation firmed and the median Committee projections for the first time implied a willingness to tolerate inflation above 2% in the years ahead. This led to some firming in inflation compensation implied by TIPS breakevens.
Eventually, however, TIPS-implied breakeven inflation fell back as inflation headed lower and the Committee continued to signal rate increases even as they lowered their own inflation projections. This combination of ongoing tightening amid frequent inflation disappointments has revived concerns about asymmetric treatment of the inflation objective.
One of many challenges facing the Fed
Scepticism regarding symmetric treatment of the inflation objective is not the only challenge facing policymakers. A slowdown in growth this year had long been anticipated by the central bank and private sector forecasters, but perceptions of recession risk over the next several years are somewhat elevated, at least judging by survey measures, and to some, by the flattening of the Treasury yield curve.
Recession concerns appear to have several sources and include risks of a monetary policy error given that the central bank has a poor track record of cooling off an overheated labor market without causing a recession. Concerns over high levels of corporate leverage, as well as anticipated declines in corporate profit margins, are also commonly cited reasons for elevated recession risks.
This leaves the Committee in an uncomfortable position. If the economy were to enter a recession over the next few years without inflation ever sustainably reaching 2%, it would likely be perceived by the public as a policy failure – the Committee had chosen to raise rates to prevent an inflation overshoot that never occurred.
A delicate balancing act
In the current political climate, such an outcome would have serious implications for the central bank’s independence. At the very least, the “Audit the Fed” movement of prior years would likely get a second wind, this time with a House of Representatives that could be even more sympathetic to arguments for greater oversight of the central bank. In addition, restarting quantitative easing would leave the central bank vulnerable to charges from politicians that it is reverting to policies that exacerbate wealth inequality.
The irony of all this is that the Committee knows full well that it is challenging to achieve the inflation objective when there are risks of returning to the zero lower bound on interest rates in a future recession. This is because difficulties providing stimulus when the zero bound is a constraint serve to depress long-term inflation expectations even in good times, and low inflation expectations hinder achievement of the inflation objective.
Market-implied breakeven inflation rates suggest that this has indeed occurred, as does the slippage in survey measures of inflation expectations. Despite low inflation and depressed inflation expectations, the Committee has arguably moved forward with policy tightening as if the zero bound will not be a constraint in the future.
Signs of a change in approach
Fortunately, there are signs of forthcoming changes to the Committee’s approach. Last November, the Committee formally announced a 2019 review of its strategies, tools and communication practices. The effort will draw on the substantial literature on alternative policy frameworks, including by John Williams, President of the Federal Reserve Bank of New York and Vice Chair of the FOMC.
The debate this year will mainly center on two possible alternative frameworks: variants of price level targeting, and average inflation targeting. The second of these has a number of advantages over price level targeting in terms of ease of communication, credibility of the commitment, and less pronounced political risks.
I suspect that the review will ultimately lead to changes to the strategy framework, possibly as early as next year. If a framework change is indeed in the offing, it raises an interesting question for the conduct of policy during the transition. Average inflation targeting, for example, requires targeting inflation a bit above 2% during an expansion, to make up for the likely shortfall of inflation in a recession.
So if, come next year, the Committee will seek to sustain core PCE inflation above 2%, how should it conduct policy in the remainder 2019? One possibility is to continue on the current course, tightening policy gradually to prevent a possible inflation overshoot, with the result that inflation expectations will remain low, and further dollar appreciation and tightening in broader financial conditions will weigh on growth and inflation. It will not help that the President will continue to criticize the Committee in this scenario, and this dent to credibility will make achieving the inflation mandate even more difficult.
Ease off on tightening and allow inflation to rise above target
A better approach would be for the Committee to use policy discretion to its fullest, easing off on projected tightening and permitting inflation to rise not only to, but even a bit above, the 2% objective, in anticipation of a regime switch.
Given this possible outcome, I am for the time being retaining my projection of two 25-basis point interest rate increases this year (with the first increase occurring no sooner than June). But risks are decidedly skewed to less rather than more tightening, and there is a good chance that the Committee will not tighten further for the foreseeable future.
An eventual change in the policy framework also suggests no further tightening in 2020, and indeed there is a risk of modest rate cuts to boost inflation above 2%. Such a shift in approach, as well as communications this year regarding a possible framework change, should steepen the Treasury curve, lower real interest rates, and support a widening of long-forward TIPS breakevens.