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Sunday, December 18, 2016

Fed Hawkishness

As expected, the FOMC raised the policy rate by another 25 basis points this week. This matches my long-time prediction for extreme ├╝bergradualism: hiking rates once per year. However, as I noted in my May article, the Fed might move to follow a slightly less gradual path: a hike every second meeting (which implies 4 hikes per year, or 1% per annum). The Fed is likely to wait until there is greater clarity on fiscal policy before becoming more activist, however.

My old boss Gerard MacDonell discusses how fiscal policy is interacting with monetary policy in "DeLong vs Krugman on fiscal stimulus." For those of us who are detached from American politics, there is considerable entertainment value in watching Democrat economists views on fiscal policy morph in response to a Republican taking the presidency (although there are reasonable concerns about the fiscal policy tools being employed).

"Full Employment"

I would note that Gerard's discussion of "full employment" would make my old school Keynesian readers unhappy (to be clear, he is referring to Paul Krugman's comments on "full employment", but I believe that he agrees with the sentiment). However, this difference is semantic (or political), and is an example of how a lot of economic arguing involves disputes over the definition of words.

Gerard is using "full employment" as it is widely used in the mainstream and market commentary: the level of employment that is consistent with a stable inflation rate under the current economic structure and institutions. In practice, a lot of people would say that this corresponds to a U-3 unemployment rate of 4-5%.

However, if we look at more Keynesian economists (such as Modern Monetary Theorists), "full employment" is would be the maximum employment that could be achieved with institutional reforms; in which case, the historical evidence would point to a U-3 unemployment rate of 2%, which corresponds to the normal level of unemployment that is created by people leaving jobs and taking time to search for new ones.  

I would argue that both sides are correct, keeping in mind the differences in definitions. Although I have doubts that inflation in the United States will rise any time soon, I believe that it could start to rise with the unemployment rate close to current level under some circumstances. A poorly-designed fiscal push is one mechanism; it would be very easy to design policies that favour regions and sectors that are already doing well, causing them to overheat -- while doing nothing for regions that are mired in under-employment.

(In other words, I do not believe that there is a well-defined "output gap" or NAIRU for the determination of the inflation rate. We could see accelerating inflation at 5%, or even 3% under the current economic structure, depending on the details of what is causing the unemployment rate to move. The argument that NAIRU moved in the 1990s -- associated with Alan Greenspan -- was just a reflection of the plasticity of the "inflation barrier.")

That said, it would be possible to change policies to drive the involuntary unemployment rate to 2%, without causing anything other than short-term blip in inflation. (Although I think this would be a good idea, I do not emphasise policy advocacy in my writing here.)

What will happen in 2017?

I am not completely convinced that fiscal policy will be revolutionary; there will be tax cuts, but their impact might be limited (other than on the headline deficit numbers). I see little sign that the Republicans are going to do anything other than tweak the economic structure, and the automatic stabilisers that are inherent in the public and private sectors will mute the impact of these changes. The Fed is going to have to go back to watching the data, and the data in 2017 will probably do the exact same things they did in 2016 (and 2015, 2014, or 2013...).

In summary, the odds are high that we will see a follow up rate hike in "mid year", with possibly a greater tempo of followup hikes (one every second meeting). For those of you who like calendar year predictions, that would imply 2-3 hikes in 2017.

(c) Brian Romanchuk 2016

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