What will the Fed do? (Jackson Hole update)

This is the sixth post in a series on the well-disguised, steady predictability of Fed policy over the last several years. Here we provide a brief update about how Jackson Hole fits in the story.

Quick review: The story is that policy is driven by consensus of a large committee as nurtured by the Chair. Because the policy decision is updated every 6 weeks, but differing views on how the economy are very persistent, it is perfectly natural that the compromise policy may, for extended periods, be far from the typical view of the 19.[1] FOMC communication explains the 19 views in excruciating detail, but largely leaves aside how these views are blended in the compromise policy. Actual policy, consequently,
may appear to be an orphan or whipping boy.[2]

But the consensus of a large, well-functioning committee will tend to evolve slowly and tend to be driven by broad themes, especially if conditions underlying the decision are largely unchanged. And by a freak of the economics gods, the top line summary of the policy conditions in the U.S. has been bizarrely unchanged. The June 2013 press conference, when Bernanke laid out the taper plan, began,

The labor market has continued to improve, with gains in private payroll employment averaging about 200,000 jobs per month over the past six months… Inflation has been running below the Committee’s longer-run objective of 2 percent for some time… The Committee believes that the recent softness partly reflects transitory factors,

The same summary would do fine for more than the next 3 years. As Yellen put it last Friday,

Smoothing through the monthly ups and downs, job gains averaged 190,000 per month over the past three months. Although the unemployment rate has remained fairly steady this year, near 5 percent, broader measures of labor utilization have improved. Inflation has continued to run below the FOMC’s objective of 2 percent, reflecting in part the transitory effects of earlier declines in energy and import prices.

The historical record is, I argue, pretty clear. Since mid-year 2013, the FOMC has predictably responded to this unchanging backdrop as if guided by two principles:[3]

So long as steady job market gains persist, continue a gradual, pre-announced removal of accommodation.

So long as inflation remains below target, take a tactical pause if credible evidence arises that the job gains might soon falter.

What does this suggest we should have heard at Jackson Hole? Since early this year, we have been in one of those tactical pauses following credible signs of a faltering U.S. and world economy and June’s Brexit vote. But the pauses up to now have ended promptly if information confirms that the job market seems on track, and if the FOMC followed this same pattern, a rate increase is coming.

As I said to some of you just before the speech,[4] there was no reason to suspect a change in the framework. If the same framework were in place, we should hear more of the sort of talk we’ve heard for three years in communication on behalf of the consensus: job market gains continuing; repeated transitory shocks still holidng down inflation; gradual rate increases continuing. That’s pretty much what happened.

A few details in Q and A form:

Q: What is the most likely scenario in which this sort of reasoning is likely to go awry?

A: Setting aside a dramatic change in economic conditions, we could be reaching a point at which the longstanding framework driving the consensus must change. We are closer to maximum sustainable employment, inflation may have begun to edge back to 2 percent, and the policy rate may soon be leaving emergency-type levels, and that weird constancy of the backdrop will presumably change at some point. Each of these may call for change in the simple framework that has been adequate for the last few years. I’d expect some fairly clear advance communication of a break in behavior on behalf of the consensus. But transitions are always tricky both to implement and to communicate, so mistaken interpretations of communication on behalf of the consensus will be more likely.

Q: What about all the other yacking about near-term policy moves?

A: Only Yellen is empowered to speak for the Committee. Whenever anyone else speaks you need to ask yourself a question: Are they explaining the committee or lobbying it? From my time on the inside, I can say that even the best outsiders regularly misjudge the answer to this question. As this series of posts is emphasizing, this other yacking is mainly important in explaining the well-disguised part of well-disguised, steady predictability.

Q: What about the yack, in particular, about secular stagnation and a lower long-run neutral interest rate?

A: This is a bit more subtle, but the communication on behalf of the consensus so far is very consistent with continued cautious steps away from zero, despite all the discussion about where rates may go in the fullness of time. It is probably useful to draw a distinction between completing liftoff vs. predicting where rates will ultimately level off. There are probably at least one or two more rate hikes to go before the policy rates leave the emergency zone and the focus of current policy choices shifts from the former to the latter. If those initial rate hikes happen, and if afterward economic conditions remain favorable, then we’ll need an update about where the consensus is headed.

Importantly, if and when we get there, that update will take place against the backdrop of a new President, new Congress, and new fiscal policy.

For now, I think people have misunderstood the importance of the lower longer-run neutral rate. Clearly, nobody can have any confidence currently about where that rate really is. But if the FOMC’s beliefs in a lower longer-term rate are shared by the public, this will have the effect of anchoring the long-end of the term structure. This, in turn, makes a near-term rate increase less risky by reducing the likelihood it will ignite a large run up in longer-term yields. In my view, the FOMC’s talking down and anchoring of the long end has had minimal effects on the likelihood of the next rate increase.

Q: What about Friday’s employment report?

A: No single employment report matters much, no matter how often analysts breathlessly tell you that the report will be critical, and no matter how many policymakers state the eternal verity, ‘we’ll be watching that closely.’ As the quotes above indicate, the FOMC consensus tends to look through month-to-month fluctuations. This year, initial prints have spanned job gains of zero to 300,000 (approximately). The consensus is, and should be, largely unaffected by this noise.

Q: September or December?

A: As many folks have repeatedly emphasized, the timing of individual moves doesn’t matter much in terms of the Fed’s dual mandate. Predicting stuff that doesn’t matter is a sucker’s game, and I’ll pass. I know that this doesn’t help those of you who are eager to place bets on this question. Others can can hedge the modest timing risk and focus on stuff that really matters.

Notes:

1. The chair repeatedly argues, “if the economy more clearly supports your view in six weeks, we’ll do your policy.” [back]

2. As always, “19” should be read as “however many policymakers are in place.” [back]

3. Note that I have been saying that policy behaves as if guided by these principles. Nobody need subscribe to these principles: the coherent and predictable policy behavior emerges as a reconciliation of the individual views. [back]

4. I am occasionally invited to speak to investor groups, and did so Thursday morning before the speech. A number of our regular readers were in the audience. [back]