What will the FOMC be discussing next December?

The FOMC has communicated that it is likely to raise the federal funds rate 25 basis points in its meeting today; it would be a major shift in behavior if it didn’t. Thus, the main thing many folks are talking about is what the Fed will signal in the Survey of Economic Projections (SEP) and its dot plot. Our advice is always to ignore the dots, and that advice goes double right now.[1]

A more revealing exercise is to examine what challenges the Fed may face in coming months and how the Powell-led FOMC may react. For many standard scenarios, the analysis is straightforward. If economic activity remains solid or picks up and inflation picks up as expected, the FOMC will raise rates promptly.[2] If the economy turns down, everyone agrees that the Fed has few attractive options, and right now nobody probably has a great handle on just which of the remaining tools would be used in what manner.

The scenario that raises interesting questions, however, is more of the same. Imagine that we see solid to good economic activity and job growth associated with robust gains for risky asset prices, but inflation moves sideways. In other words, next year looks like the last four.[3] In light of today’s CPI report and in the spirit of “fool me five times shame on me,” let’s imagine what happens if the economy continues the streak for another year or so.

There is much that sounds good in more of the same—jobs gains, rising stock market, tightening credit spreads, …. But these outcomes would push the equity premium and other measures of risk premia near all-time lows and would bring front and center questions that have been gaining steam inside and outside the Fed for some time. Do unsustainable excesses always appear first and foremost in inflation? Can the signs of too much of a good thing appear mainly in asset markets?

Up until the crisis, a dominant view inside and outside the Fed was that monetary policy should focus on promoting low and stable inflation and that, setting aside nasty real-side shocks that the Fed cannot anticipate, the main systematic threat to economic activity is overheating. An excessively buoyant economy generates upward momentum in inflation, and the economy falters amidst tightening monetary policy. In this view, dangerous excesses are almost exclusively to be found in rising wage and price inflation and their precursors, unsustainably high levels of resource utilization.

An alternative view holds that there is no reason to suppose that destabilizing excesses would always appear first or foremost in wage and price inflation and that excesses might first appear in asset markets.

In this view, the boom-bust cycle of the post-war era through about 1980 fit the inflation-driven-excesses pattern expected by the mainstream, but the dramatic events since then were better described by the asset-side excesses view. Notable events are Japan’s malaise since the popping of the bubble in the early 1990s, the U.S. recession in early 2000s following the tech bubble, and the recent financial crisis and slow recovery. This is not to mention myriad examples from emerging market economies, examples that mainstream economists, until the crisis, seemed to dismiss as not being first world problems.

As an historical aside, we note that Hyman Minsky was one of the earliest advocates of this view, but until recently he was afforded only fringe status. Beginning in the 1990s, one of your present authors, Barbera, followed Minsky in arguing for “a more expansive definition of excess.”[4] As Barbera began his transition from Wall Street back to academia in the early 2000s, he received the friendly advice to never mention Minsky, lest he be dismissed as a quack. The change of heart in academia is reflected in a recent paper by Larry Summers and Olivier Blanchard, which reads a bit like a mea culpa, noting that “Hyman Minsky (1992) had warned for decades about the consequences of buildups in financial risk.”[5]

Despite a new openness to the idea of asset-market excesses in some parts of the economics profession, the profession is nowhere close to agreeing on a new dogma. Thus, if we get more of the same from the economy, the FOMC will be forced to make policy with an appreciation that the old framework is incomplete but with no conventional wisdom on how to incorporate wider considerations into policymaking. More to the point, this scenario would probably force the FOMC to decide when, if ever, asset market excesses threaten the dual mandate and call for a monetary policy response.

Various speeches and passages in the FOMC minutes make clear that these issues are now a regular part of FOMC discussions. But this was true in the past as well. The Greenspan FOMC fretted over asset market excesses, but in our reading of history, never responded to them.[6] The Bank of England’s Mark Carney beautifully laid out the cases for and against adjusting monetary policy in light of asset market excesses, and concluded that monetary policy should be the last line of defense. In practice, one might wonder whether last line of defense will translate into used only in retrospect, as in, “We wish we’d have responded.”

So what would the Fed do in the face of more of the same from the economy? FOMC policy is made by consensus among a large group of policymakers the views of which are probably—and appropriately!?—as varied as the views outside the Fed. In this scenario, the FOMC will have to create and communicate a new consensus on this contentious and unsettled topic.

If the expanded notion of excesses is folded into the consensus, some components of the likely approach are clear. The FOMC’s monetary policy actions are always rooted in the dual mandate, so the rationale will likely rest in the link between financial conditions, generally conceived, and a sustainable level of employment. The details of this approach are, however, unclear. Specifically, taking a balanced approach[7] to the dual mandate could warrant more rapid funds rate increases despite continued soft inflation, but under what conditions, if any, the FOMC would make such a call is, for now, untrodden ground.

Overall, if the economy continues steadily along and inflation turns up, the Fed’s policy problem will look pretty conventional. If the economy turns down and inflation softens, the Fed has few highly attractive options. In a serious recession, many of us will be hoping that fiscal policy (under the brave new Republican model) pulls its weight, this time. If instead the economy gives more of the same, we’re not so sure how policy will unfold, but we’re pretty sure the issues we’ve raised will be front-and-center in the FOMC previews next December.

Notes:

1. Besides our standard arguments, most everyone agrees that the economy’s path will be meaningfully influenced by what happens in the tax bill, and this remains unclear for at least a bit longer. In addition, today’s dot plot will summarize the projections of an FOMC the membership of which is changing with unprecedented speed at present. [back]

2. Any thought that there will be a tussle over that—especially a tussle based in politics—is, in our views, nonsense. [back]

3. The pattern we are referring to is clear, for example, in the December SEPs back through 2013. [back]

4. See, e.g., the section entitled Toward a More Expansive Definition of Excess from 2000 and The Fed should care about asset prices from 1999. Similarly, your other author joined with Dale Henderson in criticizing the narrow focus of the prevailing view of inflation targeting. They argued for considering the question “[U]nder what conditions should the central bank allow or promote movements of inflation around the mean in order to promote other goals such as real and financial stability”? [back]

5. Rethinking Stabilization Policy. Back to the Future, 10/8/17[back]

6. Faust and Leeper discuss this history. [back]

7. The FOMC’s strategy statement makes clear that, “under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them.” [back]