Why did the Federal Reserve lean against their optimistic 2014 forecast? It seems that monetary policy over the past year can be summarized as a missed opportunity to supercharge the recovery, thereby locking the US economy into a suboptimal growth path.
Last week's speech by New York Federal Reserve President William Dudley noted the reasons monetary policymakers expected the economy to improve this year:
Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy. This performance reflects three major factors—the significant headwinds resulting from the bursting of the housing bubble, the shift of fiscal policy from expansion toward restraint, especially in 2012 and 2013, and a series of shocks from abroad—most notably the European crisis.
The good news is that all three of these factors have abated. With respect to the headwinds resulting from the financial crisis, they are gradually becoming less severe. In particular, the sharp decline in household wealth due to the decline in housing prices and the weakness in equity prices has been largely reversed...On the fiscal side, the amount of restraint has diminished sharply. For 2014, the projected drag is about ½ percent of GDP, roughly half the level of 2013. Moreover, much of this restraint was frontloaded into the beginning of the year...In terms of the outlook abroad, the circumstances are more mixed.
The Federal Reserve could have chosen to lean into this generally upbeat forecast. Yet instead they chose to lean against it by turning to tapering and setting the stage for interest rate hikes. And the data so far suggests that once again the turn toward policy normalization was premature. The weak first quarter report is more suggestive of holding the recent pace of growth over the next year rather than an acceleration of activity. What is remarkable is that the Federal Reserve understood that their forecasts have tended toward optimism. Dudley again:
But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch.
Yet they choose to act prior to data confirmation. Why? I really don't quite know. Sure, we can tell a story about the declining unemployment rate and expected subsequent inflation pressures, but ultimately the turn toward less policy accommodation never made sense in the context of the Fed's own forecasts and questions about the degree of slack in the economy. It makes me wonder how seriously the Fed is truly interested in closing the output gap:
It seems reasonable to believe that if the economy regains potential output by the end of at best 2016, it will be attributable only to further downward revisions to potential output. And I even wonder whether the Fed would act to achieve their current growth forecasts or ultimately be content to continue along the current trend. The economy appears to be already molding itself around the lower output path. Despite the housing troubles and related weak rebound in construction, and the declines in government hiring, job growth is, on average, plugging along at a rate roughly consistent to that during the housing boom:
With that growth labor slack gradually steadily declines by any measure, the Fed appears reasonably comfortable with the resulting path. To be sure, arguably there still remains substantial slack. The failure of wage gains to accelerate is consistent with that story. But the Fed seems content to use that story only to justify its current policy path rather than justify an even easier policy to more quickly reduce slack.
Given the generally consistent overall reaction of the labor market to the current growth path, it is reasonable to believe that the faster pace of growth in the Fed's forecast would accelerate the pace of labor utilization and thus place upward pressure on inflation forecasts. In this case, we would expect the Fed to pull forward and steepen the pace of rate hikes to moderate the pace of activity. Thus, ultimately the Fed's commitment to regaining potential output could be even less than we have come to believe.
But even more telling would be the monetary policy reaction if growth continues along its current path. The weak first quarter results already place the forecast at risk, and the housing recovery is not progressing as smoothly as initially believed. Yet neither event prevented the Fed from continuing to cut asset purchases at the last FOMC meeting. Moreover, I still can't see any reason to expect the Fed will slow the tapering process unless the economy falls decisively off its current path. It could be that by the time they are sufficiently convinced growth will continue to fall short of forecast, asset purchases will be almost complete anyway. And I think the bar to restarting asset purchases would be very high. They want out of that business.
And if neither fiscal or monetary policy makers are interested in accelerating the pace of growth, should we really expect the pace of growth to accelerate? In other words, it appears to me that monetary policy largely amounts to setting expectations that reinforce the current growth path. Which was a recent topic of Bloomberg's Rich Miller who, reporting on the Fed's diminished expectations, quotes me:
By lowering its assessment of how fast the economy can expand and conducting policy accordingly, the Fed runs the risk of locking the U.S. into a slow-growth path, said Tim Duy, a former Treasury Department economist who is now a professor at the University of Oregon in Eugene...
...“They offset fiscal austerity on the downside but then arguably also offset the upside,” Duy said. “They seem to have lost interest in speeding the pace of the recovery.”
Bottom Line: The Federal Reserve has set reasonably clear expectations that rates will remain low for a long time. That path, however, seems to be a consequence of doing too little now to ensure a stronger recovery. In other words, the Fed seems to be taking a lower-rate future as a given rather than as a result of insufficient policy. Instead of acting to ensure a stronger forecast, they seem more interesting in acting to lock-in the lower path of activity. And that in turn will tend to lock in a low level of long-term rates. This, I think, is the best explanation for the inability of markets to sustain higher rates. It is simply reasonable to expect that the conditions which justify higher long rates will be met with tighter policy sufficient to contain growth to something closer to the current path of output than to current estimates of potential output.