There was broad support, or at least acquiescence, on the Federal Open Market Committee for last week’s decision to cut policy rates by 0.25 per cent. Nevertheless, policymakers are clearly divided on the general direction of rates from now on. In his press conference, Jay Powell, Federal Reserve chairman, euphemistically remarked that there were “disparate perspectives” on the committee.
There seems to be a small plurality for further “insurance cuts”, probably including the leadership, but there is also mounting discontent about the extent and duration of the easing cycle that is now under way.
The split in the FOMC between hawks and doves is no doubt driven by many factors, but one of the main underlying differences concerns the amount of inflation risk that participants are willing to take in the late stage of the economic cycle.
The more hawkish camp believes that, with unemployment well below the natural rate, there will be further — if gradual — rises in wage inflation. These, they believe, will inevitably feed eventually into higher price inflation — a development that may already be under way, given successive upside surprises in monthly consumer price index reports during the summer.
Underpinning these conclusions is a belief that the Phillips curve, which relates wage inflation to unemployment and expected price inflation, is still alive and kicking. Harvard University’s Gregory Mankiw recently reminded the Fed that this curve has always represented “the single most important macroeconomic relationship”.
Everyone accepts that the impact of low unemployment rates on wage inflation has been substantially damped in the past two or three decades, but there is very strong resistance among the FOMC hawks, and the Fed’s mainstream economic staff, to any suggestion that it has disappeared altogether.
Furthermore, the hawkish group believes that the dampening or flattening of the Phillips curve would prove very problematic for monetary policy if inflation was allowed to rise too far above target. This is because the “sacrifice ratio”, in the form of the extra unemployment that would be needed to get inflation back down, is greater when the curve is flatter.
Hence, any inflation mistake on the upside would be more painful to correct. This makes the hawks reluctant to do more than a couple of rate cuts, seen as a midcourse correction, at the present stage of the cycle.
Why do the doves disagree with these arguments? They would deny that the recent CPI reports represent a significant change in inflation pressure. Mr Powell, an obvious dove by nature, ignored these data points entirely last week. He emphasised, quite rightly, that inflation expectations in the bond market are at the lower end of their historic range, a worrying development.
He also repeated his belief that, in a world where interest rates are constrained by the zero lower bound, the central bank should stand ready to act aggressively if it thinks the economy is worsening.
When asked if the Fed might shift rates into negative territory in an economic downturn, following the pattern in other countries, Mr Powell poured cold water on that idea. That means the FOMC would be able to cut rates by only 187 basis points in a recession (ie from 1.875 per cent to zero). This would be much less than half the easing that has been needed in previous US economic downturns.
Viewed in a global context, the lack of monetary ammunition becomes even more stark. Policy rates in Europe and Japan are already very close to their effective lower bounds for rates.
I calculate that the global average for policy rates in the advanced economies as a group, weighted by nominal gross domestic product, could be cut by only about 110bp in a recession before the central banks reach their different lower limits. This shows how close the rest of the global economy is to the limits of monetary policy, which places enormous responsibility on the Fed.
While there are inflation risks in both directions, the consequences of allowing deflationary forces to take control are particularly severe. The doves, led by Mr Powell, may not be in a clear majority on the FOMC, but they will probably get their way when the crunch comes.
After several years in which the Federal Reserve has missed its inflation target on the low side, the bond market has become complacent about upside risks to inflation. However, since midsummer, there has been a succession of US CPI inflation reports that have been significantly above expectations.
These data points have added about 0.4 per cent to the 12-month CPI inflation rate since monetary policy turned dovish in June. Together with a clear upward path in wage inflation, these CPI surprises may be suggesting that there are upside risks relative to the central bank’s inflation forecasts. (It should be noted, however, that the Personal Consumption Expenditures index, which the Fed tends to prefer to the CPI index, has risen by less, and has not yet seen similar upside surprises in recent monthly inflation reports.)
Another concern is that two special factors could add to the upward path for CPI and PCE inflation in coming months. If President Donald Trump implements all his threatened tariffs on Chinese imports, this would add more than 0.5 per cent to the inflation rate by early 2020.
On top of this, Fulcrum’s inflation model suggests that a persistent $20 a barrel increase in the oil price would add another 0.5 per cent to the inflation rate within a few months. If both these shocks apply at the same time, the CPI (and PCE) inflation rates would temporarily exceed 3.5 percent. (My thanks to Fulcrum’s Jeremy Chiu for these calculations.)