May 10, 2016

Six Degrees of Separation between Jobs and Inflation By CFEGuru

By Bob Barbera and Jon Faust

Friday’s reported increase of 160,000 in nonfarm payrolls was less than the recent average. This doesn’t mean much for the macroeconomic outlook and, therefore, shouldn’t and probably won’t mean much for the path of monetary policy.

Monthly nonfarm payroll gains bounce around a good deal and are substantially revised. Moreover, weather-especially winter weather–can dramatically affect the numbers. Remember that seasonal adjustment accounts for the typical effect of winter, not for the particular winter we experience. The CFE’s Jonathan Wright, one of the leading experts on this topic, regularly publishes a weather adjusted payrolls series. By his reckoning (reported here), this winter’s weather, including that nasty April in much of the country, may fully explain the weakness in today’s report.

More importantly from a policy perspective, we think that much discussion of the job-gains-to-policy link at present is deeply misguided. In particular, there is a view that the pace of job growth over the last year or so is dangerously high and must soon begin slowing lest we push the job market to the bursting point. In this view, we need upward adjustments to the path of interest rates until those job gains of over 200,000 a month slow considerably.

Let’s accept a deep truth: job growth at the recent pace cannot continue indefinitely: ultimately an increase in payrolls of over 200,000 per month must take the economy above any reasonable sense of sustainable employment, and this would be destabilizing. Conventional Phillips-curve reasoning goes like this. As slack in the labor market evaporates, wages are sure to accelerate. As real wage gains exceed the gains for labor productivity, corporations see their margins erode, and this prompts them to raise prices, a process that generate a destabilizing inflationary environment. By destabilizing, we basically mean that that the Fed may either respond so sharply as to risk recession or so weakly as to allow inflation to jump to unacceptable levels.

O.K., so if strong job growth persists too long it would ultimately set in motion an inflationary dynamic, and if that begins to build and prompts a Fed response that is too weak or too strong, bad outcomes would follow. But even acknowledging all that logic, still leaves us a country mile from the conclusion that we need slower job growth today.

Let’s consider instead an economy in which the job growth at a rate something over 200,000 per month continues for, say, another 18 to 24 months. The assertion that this would dangerously overheat the economy requires us to believe the Phillips curve mechanism, and also to believe that we have a pretty good grasp of the myriad factors that determine just when job gains translate into dangerous inflation pressures. At last summer’s Jackson Hole Conference, Jon Faust and Eric Leeper reviewed how well the best thinkers and policymakers have historically done in assessing these factors. The record shows essentially no relation between inflation outcomes and inflation forecasts based on real-time assessments of labor market tightness. In Faust and Leeper’s argument, the standard Phillips curve forces operate in the economy, but they are regularly swamped by those myriad other factors–disparate confounding dynamics. Faust and Leeper base their argument on the normal period before the financial crisis—you remember, back when things were comparatively simple. No one contends things are simple today, and, in our view, there is no reason to believe that the current pace for employment growth if continued for a year or two would risk a destabilizing inflationary environment.

Let us spin out these disparate confounding dynamics in the form of six degrees of separation between the current pace of job growth and those bad inflation outcomes.

1. Amid continued strong job gains, the labor force participation rate rises forestalling a tightening of the labor market

2. Amid continued rapid job gains, the labor market continues to tighten and the unemployment rate continues to fall, but sufficient slack remains so that little upward pressure on wages and prices emerges over the next couple of years.

3. Amid strong job growth, upward pressure on wages causes a rise in wage inflation, but labor productivity accelerates offsetting any inflation pressure

4. Amid rapid job growth, real wage growth rises above the rate of productivity growth, but inflation does not pick up as labor’s share of income rebounds from historic lows.

5. Amid strong job gains, inflation accelerates, but inflation expectations remain anchored and no destabilizing dynamic emerges.

6. Amid strong job gains, inflation accelerates and inflation expectations begin to climb. The Fed responds as the inflation becomes apparent, avoiding any destabilizing effects

The analysis that follows simply gives an illustration of these six points.

1. Amid continued strong job gains, the labor force participation rate rises forestalling a tightening of the labor market

Job gains need not imply a tighter labor market if the increase in jobs is met by new workers joining the labor force. Of course, it is widely accepted that the labor force participation rate (LFPR) over the longer run in the U.S. will be falling as the large baby boom generation retires. To put some rough numbers on this, take the 2016:Q1 participation rates by age cohort (Table 1, col. 2) and hold them constant for the next 2 years in what we’ll call a the no change scenario. Given the BLS’s reported population forecasts by age cohort, the demographics of our aging population over these two years would imply that the overall LFPR would fall by about half a percentage point to 62.5 percent.

Actual 2018:Q1 scenario
Age 2016:Q1 No Change Upbeat
All 63.0 62.5 63.5
16-24 55.4 55.4 55.4
25-54 81.4 81.4 83.4
55-64 64.4 64.4 65.0
65-74 27.3 27.3 27.3
75+ 8.3 8.3 8.3

Table 1. Particiaption rates by age cohort. Source: data, BLS via Fred; scenarios due to authors.

But the participation rates are not constant by cohort. For example, the participation rate in the age 55-64 cohort has been increasing for over 20 years. And the participation rate of the 25-54 group has recently been rebounding from post-recession lows, jumping from 80.6 to 81.4 over the year ended Q1:2016.

Consider the following upbeat scenario (Table 1, col. 3). The 25-54 participation rate rises for the next two years at about half the rate it rose over the 2 quarters ending in March. After two years, this still leaves it well below its pre-recession peak. The steady rise in the 55-64 participation rate continues. The participation rates in the youngest and oldest cohorts remain unchanged. Using the same population numbers used above, the overall participation rises to 63.5 percent in the upbeat scenario, as compared to a fall to 62.5 percent in the no change scenario.

The implications of these seemingly modest changes in the participation rate are quite striking when one considers the pace of job growth and the unemployment rate. For example, the median FOMC forecast for unemployment in 2018:Q1 is just below 4.6 percent. Under the no change scenario, job gains of 110,000 per month would roughly deliver this outcome. In the upbeat scenario, it takes job gains of 220,000 per month to reach that same unemployment rate.

Modest adjustments of the participation rate by age cohort over the near-term could allow the current pace of job creation to continue into 2018 while delivering an unemployment rate that the FOMC projects is consistent with inflation rising slowly to 2 percent.

2. Amid continued rapid job gains, the labor market continues to tighten and the unemployment rate continues to fall, but sufficient slack remains so that little upward pressure on wages and prices emerges over the next couple of years.

Historically, as the unemployment rate falls to 5 percent, this has signaled a relatively tight labor market and a noticeable acceleration in hourly wage gains. This regularity helps explain why most FOMC members report something like 5 percent for the long-term normal unemployment rate. In the past, however, those 5 percent jobless rates were generally accompanied by similarly low levels for other measures of labor market slack. Today, as the Fed regularly reminds us, many broader measures of unemployment remain much higher than the past relation with headline unemployment would predict.

For illustrative purposes, Fig. 1 shows the conventional (U-3) unemployment rate alongside a broader measure that we’ve constructed. The broader measure includes U-3, the rate of involuntary part time work, and a measure of prime age participation rate shortfall. From 1985 to the crisis, the two measures mirror each other, and, in particular, both measures tended to dip below 5 percent at the same time. Currently the more comprehensive slack measure stands above 6 percent–more than a full percentage point above the conventional unemployment rate.

Fig. 1. Conventional unemployment rate and broader measure. Sources: BLS via Fred, and authors’ calculations.

Given the similar behavior of these two measures in past cycles, historical data is not much help in sorting out which-if either-gives a reliable signal of when labor market tightness is causing significant wage pressures. [1] The alternative measure suggests that we may have a couple more years of labors market progress of the sort we’ve been seeing before inflation pressures emerge.

3. Amid strong job growth, upward pressure on wages causes a rise in wage inflation, but labor productivity accelerates offsetting any inflation pressure

Strong job growth could well drive the jobless rate lower and also be associated with the acceleration in wages that standard Philips curve thinking might predict. These developments could, however, be accompanied by more rapid labor productivity growth. Of course, real wage gains that are supported by higher productivity do not raise unit labor costs or put a squeeze on profits, and thereby need not put upward pressure on inflation. Given abysmal recent gains for productivity, perhaps expecting a jump in productivity sounds crazy—but we might be due for a compensating bounce. The point is that our understanding of productivity dynamics at present is quite hazy and this scenario cannot be dismissed.

4. Amid rapid job growth, real wage growth rises above the rate of productivity growth, but inflation does not pick up as labor’s share of income rebounds from historic lows.

If real wage growth exceeds productivity growth, this by definition puts pressure on profits. And in the standard slack-based account, this automatically translates into a cyclical rise in inflation pressure. But we have seen dramatic longer-term moves in profits in recent decades that are unrelated to inflation. In particular, profits as a share of national income have been abnormally high by historic standards for many years. A return to something more like normal profit conditions of the past 30 or 40 years might involve exactly the dynamic of real wages outpacing productivity described above, but with no corresponding rise in inflation.

This issue is more commonly discussed in terms of labors share of national income rather than the profit share. By most reasonable measures, labor’s share of income has been near historic lows in recent years. For example, the simplest of measure, compensation as a share of GDP, is shown in Fig. 2.

Fig. 2. Labor compensation as a share of GDP. Source: BLS via Fred.

Suppose that labor’s share were to bounce back by another one percentage point over the next two years. Given that the share is around one-half, to achieve this gain wage inflation would have to exceed the overall inflation plus the productivity growth rate by about a full percentage point for the two years.

For example, in a world of 1 percent productivity growth and 2 percent inflation, wage inflation of about 4 percent for two years would be required to achieve this modest bounce back of labor’s share.

5. Amid strong job gains, inflation accelerates, but inflation expectations remain anchored and no destabilizing dynamic emerges.

The U.S. economy has spent the past 4 years below target for both headline and core inflation with employment well-below its maximum sustainable level. Inflation expectations, at least until recently, seemed remarkably well anchored near 2 percent. Perhaps it is also possible that two more years of strong job growth would push employment and inflation above desired levels without threatening any destabilizing dynamic. The Fed has made clear that overshoots are not the intended effect of current policy. And if the overshoots happen, they clearly would involve some costs,[2] but there is no strong reason for presuming that this outcome must spiral into a destabilizing dynamic.

6. Amid strong job gains, inflation accelerates and inflation expectations begin to climb. The Fed responds as the inflation becomes apparent, avoiding any destabilizing effects

The slack-based route to inflation might, of course, emerge if the current pace of job growth continues for a couple of years. But if it does, the Fed might respond in some roughly appropriate manner and avert those destabilizing outcomes.

Leaping to the conclusion

Finally, we must acknowledge that a continuation of job gains such as those we’ve seen recently could elicit precisely the kind of destabilizing inflationary dynamic that seems to underlie much conventional thinking. Leaping to this conclusion requires us to leap those six degrees of separation. The case for intentionally promoting slower job growth at present seems to rest on this outcome being likely.

Dealing in historical reality rather than the popular myth, there is nothing to support the view that the Fed—or any economist or policymaker—understands the disparate confounding dynamics, well enough to warrant this preemptive unemployment. Yes, slowing job growth is a euphemism for more folks out of work longer.

The implications for interest rate normalization? There are many arguments for and against a gradual increase in short-term interest rates at present that do not rest on the merits of preemptive unemployment. The neutral interest rate may or may not be rising; rest of world weakness may or may not be worsening; other excesses may or may not be rising. We can have a good debate about these. The fear that too many folks will get jobs each month is not, for the near-term, a reason to tighten policy.


1. The period from 1985 to the crisis was known as the Great Moderation and is often held up as a period when monetary policy based on slack-based reasoning was a success. We designed our measure to mirror U-3 over this period and then diverge. This may sound like cheating, but it is precisely the point of the Faust-Leeper analysis. There are many, many measures of slack which share much behavior but show disparate potentially confounding dynamics. Once we find a measure of slack that performs well by some criterion over a particular period, we still need to consider the myriad other similar measures that perform well over that period, but diverge after. [back]

2. And also some benefits. For example, the long undershoot of 2 percent inflation has led to an appreciable rise in the real future tax burden imposed by the government debt. Reversing some of this would be one benefit of an overshoot. [back]

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March 26, 2016

Beyond the dots By Jon Faust

Since the last FOMC meeting, we have again heard cries of lost Fed credibility and of general confusion. In contrast, my colleagues and I at the CFE have been arguing for many months now that we would likely see what has in fact transpired. In our view, the Fed’s actions, including those at the March meeting, are consistent with a credible and consistent commitment to begin interest rate normalization while continuing to support continued improvement in the labor market with inflation moving back toward two percent. We suspect this may sound, well, nuts to some readers, but the case is fairly brief, so we invite you to take a look.

After the March press conference, Chair Yellen explained that the FOMC was proceeding cautiously, in order to ‘verify that the labor market is continuing to strengthen despite the risks from abroad,’ and further noted that,

[M]ost Committee participants now expect that achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time.

Just before the January FOMC, we wrote

[T]he FOMC statement and discussion thereafter is unlikely to imply any fundamental change [in the likely course of policy], instead it may signal a pause to refresh the view on the macro fundamentals….If something like our forecast comes to pass, any pause will evolve into a much slower pace of rate increases than are implied by the FOMC’s December rate projections.

This echoed our prediction on the eve of the December FOMC that we would see a ‘prudent liftoff that is again followed by considerably slower rate increases than those reflected in the median FOMC rate projections.’

While things have evolved very much as we described, much commentary has suggested that the Fed has been confusing, denting its credibility and signaling another major shift in the hawk-dove tug of war that ostensibly dominates policy.[1] As it turns out, we predicted this commentary as well:

[C]ommentators will stumble over themselves in a race to divine whether hawks or doves have taken over the FOMC and will guide policy going forward. In our view, the FOMC statement and discussion thereafter is unlikely to imply any fundamental change…

This last prediction is a no brainer, of course. Commentators stumble in this way after most FOMC meetings, despite the fact that the FOMC never signals fundamental change in a way that requires such divination.

So where does our view differ from that of others? Since I returned to the CFE from the Fed about a year and a half ago, my colleagues and I have been pushing some basic—one might almost say mundane—principles for interpreting the FOMC. Under these principles, the current situation is not so opaque.

1. Policy is driven mainly by macro fundamentals. The best understanding of those fundamentals is pretty hazy but changes little between any two FOMC meetings.

2. The FOMC is a large committee (19 when fully staffed) with membership chosen to include a wide variety of views. Unlike some bodies in Washington, FOMC decisions tend to represent a constructive compromise with broad-based support.

The consensus of a large committee like this tends to change slowly: it is hard to shift a carefully constructed consensus without strong cause, and macro fundamentals seldom give strong cause. Thus, interpretations of FOMC actions that rely on a major shift in the outlook or in the FOMC response to the outlook will very generally be wrong. We need two more principles, however:

3. Periods of heightened stress in financial markets often lead the FOMC to pause plans in order to reassess conditions. Consistent with the first principle, market volatility will not have any lasting effect on the stance of policy unless the disturbing market signals are subsequently confirmed by macroeconomic fundamentals. We discussed this notion more fully in the January post.

4. The FOMC’s Survey of Economic Projections, in general, and the dot plot of policy projections, in particular, should never be taken at face value. Given a choice between taking the dots at face value or ignoring them entirely, you are far better off ignoring them. We have made the case for this view a number of times over the past 18 months.

So let’s look back to just before the December FOMC, when the Fed had clearly signaled that liftoff was likely. We observed that for a very long time, the Survey of Economic projections had paired a sensible macro forecast with a projected path of policy interest rates that seemed more hawkish than could be consistent with the macro forecast. In short, you could have the macro forecast or the hawkish rate path, but not both. Remember that since the inception of the dot plot, this pattern has held—the inaugural dot plot was arguably inconsistent with the Fed’s own forward guidance.[2] After the individuals on the committee make these projections containing these mutually inconsistent elements, the consensus of the FOMC has, each year, chosen to implement a lower rate path in order to support something like the outcomes in the baseline macro forecast.

Our December assessment was nothing more than the prediction that this oddity would continue. The period since December has seen little in the U.S. macro data that would change this view, but the financial volatility would warrant a pause to reassess. Then in the March projections, we added another chapter in the annual downward revision of the dots. This year it seems to have become clear to the FOMC somewhat more quickly than in prior years that the macro forecast would require a more gradual tightening than originally reflected in the dots.

This story holds together, we think, but it does beg the question as to why the dots have this confusing feature. Chair Yellen weighed in on this in 2014 when asked about the hawkish tone of the dots:

I can’t speak for why people write down what they do… I think that one should not look to the dot plot, so to speak, as the primary way in which the Committee wants to or is speaking about policy.

We don’t know what’s behind these projections either. Pressed for a story, however, we offer the following speculation. The dots may have an ‘aspirational’ quality: policymakers, just like the rest of us, hope that desirable macroeconomic outcomes will turn out to be consistent with briskly moving back toward more normal rates. Wouldn’t it be grand if we could normalize rates and still have the recovery we all want? Projections with this aspirational tone can be looked at as conditionally credible: if the economy evolved in a way to allow both the macro outcomes and the rate increases, the FOMC would probably happily deliver. Unfortunately, macro reality has not supported these aspirations, and policymakers again this year are set to deliver a more accommodative path than originally reflected in the dots.

In our view, the FOMC has credibly committed not to a particular path of policy interest rates, but to delivering a stance of policy that leads to continued progress in the labor market and leads—once transitory shocks abate—to inflation returning to 2 percent. The FOMC has behaved in a manner consistent with that view. And those dots? The FOMC may even be signaling that it would prefer quicker to slower normalization, all else equal. But all else is seldom equal and, ultimately, the economy has continued to determine a slower pace of rate increases.


1. e.g., the Financial Times on March 17, 2016 quotes an analyst saying,‘I was shocked by the degree of dovishness.’ [back]

2. By April 2012, this problem was sufficiently glaring that Steve Liesman asked the following at the press conference:

Mr. Chairman, according to the latest forecast, 10 members of the FOMC see a 1 percent or higher fed funds rate in 2014; 7 of them see a 2 percent or higher fed funds rate. Under that-those conditions, how can the guidance in the statement, that you remain exceptionally low through late 2014, be justified? And is there a point at which the dissonance between the individual forecasts and the guidance get to a point where one or the other is no longer tenable?  [back]

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March 14, 2016

U.S. Monetary Policy: Three Hard Questions By Jon Faust

Since the market turmoil began early this year, Fed officials across the spectrum have been emphasizing that incoming U.S. macroeconomic data have remained broadly consistent with the baseline outlook that prevailed at year end. The economy is on track to create between 160,000 and 260,000 jobs a month and, once those nagging transitory disturbances abate, inflation will head slowly back to 2 percent. Given the excessive focus market volatility sometimes commands, Fed officials are right to emphasize this point about the baseline.

But the baseline outlook is the easy part of policy at present. The hard part is assessing upside and downside risks and how they should affect the near-term path of policy.

How can we tell that this is the hard part? One tell-tale sign came in the last FOMC statement. Fed policymakers have for many years given a balance of risk assessment in the statement, but that assessment was absent in January. The minutes of the January meeting suggest an explanation for its absence: policymakers were all over the map on risk management issues.

The upcoming meeting gives the FOMC another shot at answering three hard questions at the heart of the policy debate at present: Are downside risks elevated? What risks sit on the other side? And how will policy balance the upside and downside risks?

The return of the balance of risk statement would be a modest step in the right direction, but this statement is woefully inadequate at present. A simple story illustrates why.

An airplane is flying at 100 feet of elevation. The pilot reports to his passengers that the risks of wind gusts driving the plane up or down by about 100 feet are balanced. While this is useful information, we might forgive the passengers for wanting more. The risk of these outcomes is balanced, but the consequences are profoundly different. The pilot has standard tools for stabilizing the plane after the upward gust; the tools for responding to the downward gust involve sirens and first responders.

Suppose we accept a baseline outlook with the economy cruising at low altitude, interest rates near zero, and inflation expected to remain too low for at least another year. Downside economic outcomes would bring further disinflation and a potential recession in a global economy already showing real strains. The Fed has unconventional tools for responding to these outcomes, but they have proven to be of modest value.

The FOMC laid out the dangers that may attend an upside macroeconomic surprise when it raised the federal funds rate in December. Policy makers echoed Milton Friedman in pointing to long and variable lags between the implementation of policy and when its main effects appear. If too much accommodation is maintained for too long, the Fed risks sowing the seeds of future overheating and financial excesses—outcomes that might, in turn, demand a Fed response sharp enough to risk recession.

While much is murky, a few things seem clear about monetary policy at present. The baseline outlook—continue cruising at low altitude—is largely a sideshow, and dangers linked to upside and downside surprises are front and center in the policy debate. How the FOMC should guide policy to balance these risks is understandably controversial. In this environment, policy can either contribute to greater uncertainty or act as a stabilizer, and public understanding of policy can make the difference between these two outcomes. This puts an extra burden on the FOMC to explain policy. In my view, transparency at present starts with those three questions: Are downside risks elevated? What risks sit on the other side? And how will policy balance the upside and downside risks?

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February 20, 2016

Improving conventional unconventional policy By CFEGuru

By Bob Barbera, Jon Faust, and Jonathan Wright

The Fed has taken the position that the distressing signals from around the world do not clearly warrant a large and definitive downward shift in the outlook for the U.S. While some folks might argue that point, let’s accept it. There is, nonetheless, a heightened probability of some sort of downturn, and policymakers and others are considering what responses to that dark outcome are available. The metaphors are not pretty: Is the cupboard bare? The ammunition chest empty? With some central banks around the world targeting negative nominal interest rates, analysts are questioning whether that particular ammunition is more likely to blow up in our faces than to hit the target.

From the U.S. perspective, we think the debate is missing a key element: policy options in the U.S. look substantially different from those in the euro area or Japan. Specifically, the 5-year Treasury yield in the U.S. is now about 120 basis points, while these yields are negative for Japan and Germany. The U.S. 10-year yield is near 175 basis points, while those yields for the other two nations are near zero. The U.S. has room for more than 100 basis points of accommodation in longer-term yields that is not available elsewhere.

Pushing longer-term rates down using asset purchases has, over the past 8 years, become the conventional form of unconventional policy. And, while debates continue about how much stimulus comes from such policies, most reasonable estimates suggest that the effect is modest, but positive. (The magnitude and sign of the net effect of negative rates is less clear.)

Moreover, if times become truly desperate, the Fed could opt to employ what is likely to be an even more potent form of conventional unconventional policy: directly capping some longer-term yields. (more…)

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February 10, 2016

Are the Saudis Thinking Clearly? And Should We? By Bob Barbera

Saudi Arabia slashed oil production in the mid-1980s as prices plunged. Not so Today:

Fig. 1. Saudi Arabia Oil Production, 1,000 bbl/day. Source: EIA Monthly Energy Review via Jim Hamilton’s Econbrowser.

Given Saudi Arabia’s long-standing commitment to act as swing producer to stabilize prices, current Saudi behavior raises big questions. Why is Saudi Arabia pumping at historic rates in the face of a collapse in the oil price? And, as President Obama’s state of the union message highlights, what should be the U.S. policy response?

Let’s take it as given that the Saudis remember how to cut production by two-thirds as they did when oil prices fell by about two-thirds in the early 1980s. This time they have increased production in the face of a similar fall. Indeed, the Saudi’s are now pumping more oil than they did in 2008 when the oil price was well over $100 per barrel. What’s so different today?

Perhaps we should start with what’s been the same since the 1970s. (more…)

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February 6, 2016

Still Crazy After All These Years By Jon Faust

For the past several years, the Congressional Budget Office has been offering frightening forecasts about government debt growing out of control unless strong action is taken. While these forecasts have played a prominent role in policy debates, the CFE’s Jonathan Wright and Bob Barbera have for several years been arguing that those forecasts are, well, crazy. Or as the headline on Bob’s 2014 FT piece put it: “Forecasts of U.S. Fiscal Armageddon are Wrong.” The key to their argument—in the FT, here, and here —is that the CBOs economic growth and interest rate projections jointly make no sense. For the more complete argument see their pieces, but the gist is that under the CBO’s projected tepid growth projection, interest rates were highly unlikely to rise to the assumed levels.[1]

Jonathan discussed these issues with CBO forecasters in early 2014, arguing that it was implausible that government borrowing rates would rise to the levels CBO was projecting in the main scenario. Checking back today, same story. The CBO is projecting that the Treasury 10-year yield will rise above 3 percent in Q4 this year. Taking bets on that? The implausibly high rates continue to greatly exaggerate the debt problem.[2]

We were glad to read in Greg Ip’s recent column that Doug Elmendorf, the CBO director responsible for those forecasts until recently, now agrees. Elmendorf and Louise Scheiner of the Hutchins Institute make the argument that,[3]

…the fact that U.S. government borrowing rates are at historical lows and likely to stay low for some time, implies spending cuts and tax increases should be delayed and smaller in size than widely believed.

It was Elmendorf’s CBO that helped stoke those widely-believed views now labelled as misguided. And as noted above, the CBO is still stoking.

For the sake of coherent public policy, we hope that the CBO will listen to Elmendorf and Scheiner.


1. The interest rates were plausible, perhaps, but only if growth rebounded. In either case—low interest rates and growth or higher rates and higher growth—the budget picture looks much better. [back]

2. We are arguing, like Elmendorf and Scheiner discussed in the text, that the fiscal issues are far less severe and less pressing than they’ve been portrayed. We can still have a lively discussion regarding just how much of a problem, if any, remains once we take this fact on board. [back]

3. Hutchins Working Paper 18[back]

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January 29, 2016

Lunch and Tea with the Forecasters Club of NY By Jon Faust

If you had your TV set tuned to CNBC… August 21, 2001, two commentators were watching Alan Greenspan get out of a car and head to his office. They discussed the color of his tie (maroon) and the brand of shoes he appeared to be wearing (Rockports).’
         Danny Hakim, New York Times[1]

Yesterday, I had a great visit with the Forecasters Club of New York. Here are my slides. As we were chatting, a question came up about the Fed’s change in its strategy statement. This question has surfaced many places since the FOMC meeting, and my view about it flows directly from the no tea leaves approach to interpreting Fed communication that I’ve been pushing.

When there is a significant change in the Fed’s assessment of the outlook or in its likely reaction to the outlook, in this view, the Fed will probably attempt to tell you that directly. Because the world is complicated and communication is hard, those statements won’t be as clear as anyone would like—we’ll still need those Fed analysts. Important news will not, however, be signaled by obscure signals and signs.

Of course, the life of a tea-leaf-watcher is far more entertaining. The FOMC’s projections alone are a veritable vat of soggy tea leaves, and then there’s the Chair’s tie (or scarf). As of Wednesday, it looks like we can add the annual revision or nonrevision of the strategy statement to the list of tea leaves to be pondered.

Since 2012, the Fed has followed the tradition of reaffirming each January, possibly with revisions, its Statement of Longer-run Goals and Policy Strategy. In this year’s version, the FOMC added language clarifying that the 2 percent inflation goal was symmetric: “The Committee would be concerned if inflation were running persistently above or below this objective.[2] ” I can just imagine the dialog leading to this dramatic change:

Chair: How can we signal our dovishness?

Fresh-faced staffer: We could attempt to say something straightforward in the FOMC statement.

Chair: Who’s the new person? How about some serious ideas?

Savy staffer: I’ve got it. January is the month we revise our goals and strategy statement. We could slip something in there.

Chair: Brilliant. What scarf should I pair with that?

The symmetry now embedded in the strategy statement has always been FOMC policy. Symmetry has regularly been asserted by policymakers, and I suspect that no current or recent FOMC member has ever said anything to the contrary. This January may have been an appropriate time for the FOMC to be sure the public understood this point, but I don’t think it reflects any change in views or signal about the near-term course of policy.[3]

In the no-tea-leaf interpretation, the FOMC on Wednesday said that this year’s macro data and market moves have the FOMC’s attention, but are still too recent to warrant a definitive and pronounced shift in the U.S. outlook. As the presence or absence of a significant change in the outlook becomes clearer, the FOMC will, as always, adjust policy as appropriate.

What I’d like to hear from the FOMC is a clearer statement about their assessment of the likelihood of recession[4] and about how policy would likely respond. And by the way, the ‘balance of risks’ statement—or absence of such a statement—is a grossly inadequate vehicle for conveying that information. But that’s a subject for another day.


1. Quoted in All the People, Joy Hakim, 2003, p231. [back]

2. The use of the subjunctive tense here is entirely appropriate, but it does kind of invite a waggish lad to add, “You know, for example, if persistently low inflation were ever to happen.” [back]

3. So why was it not explicit before? Not sure, but we can speculate. Perhaps it was not included because between the original penning of the statement and the 2015 revision, questions over symmetry were not so pressing in practice, and the FOMC was not so aware of public confusion on this point. Policymakers, in this view, included the clarification so that they didn’t have to keep answering questions on the topic. [back]

4. And throw in the likelihood of a substantial overshoot of 2 percent inflation. [back]

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January 26, 2016

The Pause that Refreshes By Jon Faust

How will the Fed respond to the recent drops in the stock market? We might get a hint from the Fed’s conduct after last August’s turbulence, which now looks like a dress rehearsal for the current problems. In that event, the Fed chose to forgo the widely-signaled liftoff in September, but then implemented liftoff amid quieter markets in December. The lesson? In my view, the main lesson is that market distress may lead to a pause in policy plans, but unless macro fundamentals soon echo the market distress, the Fed will not meaningfully alter the course of policy.

I think there are two keys to understanding this lesson. First is Paul Samuelson’s quip that the market has called 9 out of the last 5 recessions.[1] Second is the fact, often repeated in the run up to liftoff, that the precise timing of any given policy action is of almost no importance.

Samuelson’s wisecrack is often taken to imply that the market gives highly unreliable signals about the state of the economy. But you don’t have to be Nate Silver to realize that calling 9 out of 5 recessions would indicate impressive predictive value. Taking Samuelson’s statement literally, more than half the time when the market signals recession, a recession ensues. In reality, the stock market probably is not as good a predictor as suggested by Samuelson, but stock market drops nonetheless reliably signal a heightened risk of recession.[2]

Given all the false signals, a market drop probably should not change ones view of the modal—that is, most likely—scenario much, but such drops can still suggest a significant rise in the probability of less likely, but far darker, scenarios.

Here is where the second point comes in: if the Fed has in place a policy trajectory that is appropriate for the modal scenario, there is essentially no cost briefly pausing the implementation of that trajectory to reassess macro fundamentals in light of a worrisome market signal. The effect of policy on the macroeconomy depends mainly on the expected course of policy over the next several quarters and years. Shifting the timing of any given policy move forward or backward a couple of FOMC meetings will have implications so small we cannot hope to measure them.

It is also important to note that no variable, not even the stock market, sends a reliable signal about recessions very far in advance—the stock market signal tends to be roughly contemporaneous. Thus, the Fed can get a reading on the validity of the stock market signal fairly quickly. If the stock market signal turns out to be a false alarm, the Fed can return to the previous course. The pause will have essentially no implications for the macroeconomy.[3]

In the world I’m discussing, the overall stance of policy is determined by macro fundamentals, with financial market signals occasionally putting wrinkles in the near-term timing. Chair Yellen’s explanation for the failure to liftoff at the September meeting squares with this view:

[I]n light of the heightened uncertainties abroad and a slightly softer expected path for inflation, the Committee judged it appropriate to wait for more evidence, including some further improvement in the labor market, to bolster its confidence that inflation will rise to 2 percent in the medium term. Now, I do not want to overplay the implications of these recent developments, which have not fundamentally altered our outlook. The economy has been performing well, and we expect it to continue to do so. [cite]

Here Yellen reiterates statements made by several policymakers before the September FOMC meeting that the U.S. outlook had not significantly changed. Some analysts take this fact as implying that policy should be unaffected, which then leads to the logic that the policy delay was a loss of nerve. Edward Luce put it this way just after Yellen’s September press conference:

So that is cleared up then. The Federal Reserve wanted to raise rates in September but then lost its nerve over China’s stock market crisis. Instead, it will probably move in December. No harm done.

The return to normal is on course barring a minor hiccup in the schedule. That, at least, was the gist of Janet Yellen’s message. Yet she also hinted she could simply repeat last week’s line in December.[cite]

Under this logic, the “gist of Janet Yellen’s message” must have amounted to Yellen making a tentative forecast of greater FOMC courage in December. My account (for better or worse) depends less on serial mood switching of the FOMC.

The modal outlook had not changed much, but the Fed was altering the near-term timing of liftoff—a move of little consequence—in order to reassess macro fundamentals in light of the market signal. If the market signal was not followed by the bottom falling out of the macro data, the previously signaled path would be resumed.

So what does this mean for policy in coming months? As in the weeks before September’s FOMC, policymakers have been out noting that near-term volatility has not greatly altered the modal outlook. It basically never does, which is Samuelson’s point. But pausing to assess whether macro fundamentals are turning seems even more clearly warranted than at the time of last September’s meeting.[4]

Let me add two forecasts. First, after the FOMC statement is released tomorrow, commentators will stumble over themselves in a race to divine whether hawks or doves have taken over the FOMC and will guide policy going forward. In our view, the FOMC statement and discussion thereafter is unlikely to imply any fundamental change, instead it may signal a pause to refresh the view on the macro fundamantals. If things quiet down and the macro economy continues to chug along, policy will also chug along, fundamentally unaltered, after a brief delay.

Second, as Bob Barbera and I have emphasized in a series of recent posts, we are not so sanguine about things chugging along. Instead, we see a darker picture for China and a weaker inflation outlook than seem consistent with the FOMC policy projections. If something like our forecast comes to pass, any pause will evolve into a much slower pace of rate increases than are implied by the FOMC’s December rate projections. Information arriving since we wrote this in December has nudged us further in the same direction.


1. “Science and Stocks,” Newsweek, September 19, 1966, p. 92 [back]

2. Much research supports the basic facts about the stock market lying behind Samuelson’s point. A nice recent piece on this is Bluedorn, et al., Do Asset Price Drops Foreshadow Recessions? IMF working paper 13/203. [back]

3. In this post, I am not arguing that the pause-tactic is optimal in any sense. I am arguing that it is a reasonable tactic and is how the FOMC seems to be behaving. For readers interested in formal optimality, I think it is clear that if properly communicated the conventional costs and or benefits of pausing would be second order. If I were attempting to build an interesting optimality argument, I’d include nonlinearities in the market signal, inherent nonlinearities in recessions which are magnified at the zero bound. Additionally, I’d take a world of imperfect information in which a pause might provide for more effective signal of conditional support for the economy in the event of recession than, say, would a simple Fed announcement conveying conditional support. [back]

4. The market signal is stronger and there are more negative hints showing in the U.S. macro data. [back]

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January 15, 2016

2016 Starts with a Bang–Or was that a Pop? By CFEGuru

By Bob Barbera and Jon Faust

When last we posted, we were making the case that a 25 basis point rise in the federal funds rate, paired with a sufficiently gradual tightening thereafter, was a reasonable hawk/dove compromise for the FOMC. Under our outlook, sufficiently gradual was likely to be a good deal more gradual than the FOMC was predicting, however. Our research suggests that conventional slack-based reasoning doesn’t provide much guidance on inflation, and that disparate confounding dynamics of other variables often dominate.[1] Chinese economic outcomes are one such factor, and we argued that China was likely in worse shape than was generally recognized. For this and other reasons we were projecting that inflation would once again come in below what the FOMC was projecting.

A couple weeks into the New Year, it’s tempting to claim that we nailed it. But that’s not right. With plunging Chinese share prices, oil in the vicinity $30 a barrel and the Renminbi in retreat, 2016 has already been a good deal more dramatic than we could, with a straight face, say we expected.

These developments will inevitably call into question the wisdom of the Fed’s December move. Is the current turmoil the Fed’s fault? Was liftoff a mistake?

We think the Fed’s actions played no central role in the recent turmoil. China’s woes are largely home grown, and the continued spectacular fall for oil prices reflects a complex interplay between new technologies, geopolitics, and a newfound Saudi Arabian willingness to pump with gusto at low prices. None of these confounding elements would look different with a fed funds rate at 12 basis points instead of 36 basis points.

Of course, nobody seriously believes that the 25 basis points alone could matter much—it is what liftoff might imply for the future course of policy that could be momentous. On this front, the FOMC spent much of 2015 trumpeting the nature of the hawk/dove compromise discussed above: liftoff was coming but the rise in rates thereafter would be more gradual than previously anticipated. The message seems to have gotten across: the expected path of rates arguably looked more accommodative at the end of 2015 than at the beginning.

For example, in December 2014, the median FOMC projection had the federal funds rate rising to 0.9%, 2.4%, and then 3.4% over the ensuing three years. At the time of liftoff in December 2015, the comparable projection for 1 year ahead is a bit higher, but rate expectations were the same as or lower thereafter (Table 1). The policy interest rate expectations reported in the survey of primary dealers show the same pattern.[2] If pushing the expected policy rate too high has been a mistake, it was a mistake committed by late 2014 and a mistake that moderated a bit in 2015.[3] There was certainly no tightening shift of a magnitude that might be expected to trigger the problems that may lie behind the recent turmoil.

Table 1. Federal Funds Rate Projections
     Years in the future
1 2 3
FOMC Survey
    Dec. 2014      0.9 2.4 3.7
Dec. 2015   1.4 2.4 3.3
Dealers Survey
Dec. 2014   0.9 2.2 3.2
Dec. 2015   1.2 2.2 2.9

Note: Projected federal funds rate (in percent) 1, 2, and 3 years from the survey date in the left column. Taken from the FOMC Survey of economic projections [2014, 2015] and from the N.Y. Fed’s Primary Dealers survey. Rates are the medians across respondants, reflect the midpoint of the target range where appropriate, and are rounded to the nearest tenth.

Regardless of the source of recent distress, liftoff could still prove to have been a major mistake. Once again, 25 basis points are hardly worth discussing. Liftoff could become a mistake, however, if the FOMC felt compelled to stay on a tightening path in the face of evidence warranting a reversal. Policymakers are probably as averse as the rest of us to backtracking from a difficult decision. If the FOMC were to show this aversion while incoming information reinforced what we have seen so far this year, that 25 basis points of reasonable hawk/dove compromise could mushroom toward the sort of big mistake that pundits have been trumpeting.[4]

This ugly outcome seems unlikely. At her December press conference, Chair Yellen was asked how the FOMC would feel about reversing course, and gave the right answer:

I’m not denying that there are situations where central banks have moved too early. We have considered the risk of that. We have weighed that risk carefully in making today’s decision. I don’t believe we’ll have to [reverse course]. But … as the Committee has said, we’re watching economic developments closely, and we will adjust policy in whatever way is necessary to support the attainment of our objectives. [source]

Fed officials across the spectrum have be emphasizing this same line.[5]

Thus the stage is set for a policy pivot if the tone of incoming news does not change. Should this scenario continue looming large, we hope that we get clear direction from the FOMC, and not the version of FOMC transparency in which 17 policymakers transparently express 17 views, leaving policy as transparent as Chinese GDP.


1. Faust and Leeper made this case in their paper, The Myth of Normal , presented at last summer’s policy symposium at the Jackson Hole. [back]

2. Yield-curve-based measures of expectations tell a similar story. For example, the Treasury 10-year yield just after the December meetings in 2014 and 2015 were essentially the same. [back]

3. To be fair, many critics do say that the Fed has been too tight all along. Without debating this view, our point is that the expected path of policy did not become appreciably tighter over 2015. [back]

4. e.g., here.  [back]

5. e.g., Presidents Rosengren and Bullard[back]

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December 24, 2015

China’s economic performance and other puzzles By Bob Barbera

Commodity price collapses tend to be a reliable signal of a broad-based global slowdown. For example, drops of 15 to 20 percent in CRB raw industrial commodities index [1] have reliably been associated with significant slowdowns in growth (Fig. 1).[2] The recent fall in commodity prices exceeds any decline since 1980 save the one registered during the depths of the global crisis of 2008-2009 suggesting a major slowdown.

Notes: Growth in red (right scale), commodity prices in green (left scale). Four-quarter change in the log of the quarterly average CRB/BLS raw industrials index; source: Bloomberg. Year on year percent change in world GDP at constant prices; 2015 data are forecast; source IMF WEO Oct. 2015 database.

So far, though, official tallies only suggest a modest global growth slowdown in 2015, and a popular story line envisions a sharp 2016 GDP growth slowdown that would validate the powerful fall for commodity prices. This may turn out to be correct, but the timing would be peculiar. Historically, commodity prices have moved largely coincident with big shifts in growth, and have not led them.

Another possibility deserves serious consideration: (more…)

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