The minutes of the May Federal Reserve meeting reveal central bankers remained poised to raise interest rates again in June:
With respect to the economic outlook and its implications for monetary policy, members agreed that the slowing in growth during the first quarter was likely to be transitory and continued to expect that, with gradual adjustments in the stance of monetary policy, economic activity would expand at a moderate pace, labor market conditions would strengthen somewhat further, and inflation would stabilize around 2 percent over the medium term…
…Members generally judged that it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory before taking another step in removing accommodation.
With incoming data brighter and suggesting that the first quarter slowdown was indeed temporary, a June rate hike looks more certain than not. But why are they even contemplating raising rates at all given recent inflation numbers? And how long can the Fed stick with its current rate hike trajectory with inflation persistently below their 2 percent target?
The Fed finds itself stuck in a conundrum of low inflation despite low unemployment. One interpretation of this situation is that it is not a conundrum at all. The Fed’s estimates of the natural rate of unemployment are too high, and hence unemployment isn’t really all that low.
The other interpretation is with unemployment low and projected to be lower, it is only a matter of time before the inflation shoe drops. As noted in the Fed minutes:
Labor market conditions strengthened further in recent months. At 4.5 percent, the unemployment rate had reached or fallen below levels that participants judged likely to be normal over the longer run. Increases in nonfarm payroll employment averaged almost 180,000 per month during the first quarter, a pace that, if maintained, would be expected to result in further increases in labor utilization over time.
This is the potential outcome that keeps Fed Chair Janet Yellen and her colleagues gently resting their feet on the brakes.
To compare inflation-unemployment dynamics during the last three tightening cycles, I use here the estimate of the non-accelerating inflation rate of unemployment (NAIRU) produced by the Congressional Budget Office and core Personal Consumption Expenditures inflation. I assume for consistency that the Fed has a 2 percent inflation target throughout this period, but that is technically true only since 2012.
Consider the late 1990s. The high productivity growth and rising dollar environment kept downward pressure on inflation even as unemployment fell as low as 3.8 percent:
Will history repeat itself? Should the Fed take the chance that history will repeat itself? There are risks to such a strategy. Inflation eventually did take hold, accelerating in 2001:
The return of inflation spooked the Fed enough that they hiked rates 50 basis points in May 2000, the last hike of the cycle. In retrospective that final hike was too much, too late and helped set the stage (or at least worsen) for the 2001 recession. One lesson learned: Even in a favorable macroeconomic environment, there are limits to how low the Fed can let unemployment fall.
Contrast this with the next hiking cycle, initiated by former Fed Chair Alan Greenspan and concluded by his successor Ben Bernanke. The post-2001 economy saw stagnant to falling productivity and a weaker dollar. It also experienced higher inflation with a smaller unemployment gap:
Greenspan had the best of both worlds, whereas Bernanke arguably had the worst. But the lesson learned was again that unemployment cannot be reduced indefinitely without triggering higher inflation, and once the Fed allowed unemployment to fall too low, reversing course was very difficult and likely to conclude in recession. It is no wonder then that current Federal Reserve Chair Janet Yellen repeats the concern that:
…waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.
This time around, the Fed faces low productivity but a generally stronger dollar. And the unemployment-inflation dynamic is splitting the difference between the past two tightening cycles:
Stuck in the middle, so to speak. Will the economy face a positive productivity shock that further reduces inflationary pressures? Or will the dollar continue its recent slide with the opposite impact on inflation? Will low unemployment finally start to kindle an inflationary fire? Or is the estimate of the natural rate of unemployment still too high? Interestingly, the minutes suggest that the majority of central bankers expect it more likely than not that these dynamics play out in such a way that the Fed needs to steepen the path of tightening:
Several participants, however, pointed to conditions under which the Committee might need to consider a somewhat more rapid removal of monetary accommodation--for instance, if the unemployment rate fell appreciably further than currently projected, if wages increased more rapidly than expected, or if highly stimulative fiscal policy changes were to be enacted. In contrast, a couple of others judged that the Committee could withdraw monetary accommodation even more gradually than reflected in the medians of forecasts in the March Summary of Economic Projections, noting that slack might remain in the labor market or that inflation was not very sensitive to declines in the unemployment rate below its estimated longer-run normal level.
The Fed, it seems, is biased toward more tightening not less - a situation that doesn't seem tenable if inflation remains persistently low as the year drags on.
Bottom Line: The bar to scaling back the Fed’s plans appears fairly high and requires either a more evident slowdown in growth that is likely to stabilize the unemployment rate or a substantial downward revision of NAIRU estimates. Until then, policymakers look committed to the middle ground of gradual removal of accommodation.
