The chart tracks the economy’s progress toward the central bank’s target of “stable prices and maximum employment.” The Fed’s rate-setting Federal Open Market Committee (FOMC) has operated under this so-called dual mandate since Congress amended the Federal Reserve Act in 1977. In recent years, the Fed has interpreted “stable prices” to mean a rate of inflation close to 2 percent per year, as measured by the annual change in the price index for personal consumption expenditures (PCE). It interprets “maximum employment” to mean the highest level that is consistent with its 2 percent inflation goal, currently thought to be an unemployment rate of about 4.8 percent.
We can use the two components of the dual mandate to draw a bullseye that the Fed is aiming for. Here is how things are going, seven years into the recovery from the Great Recession. (All data shown in the chart are quarterly, except for the last point, which shows the latest, still-incomplete data for the fourth quarter of 2016—unemployment of 4.6 percent for November 2016 and PCE inflation of 1.5 percent for October.)
As recently as the fourth quarter of last year, the Fed was missing the inflation target by a wide margin on the downside and the unemployment target by a smaller margin on the upside. Small wonder, then, that when the FOMC raised interest rates at its December 2015 meeting, many critics saw such an action as premature. That was especially true for those who hold the orthodox view that 2 percent inflation is a not an unconditional ceiling, but rather, a target that may acceptably be exceeded for a time after a long period of below-normal price increases.
Over the past year, though, the situation has changed considerably. As the chart shows, over a five-year stretch starting in 2010, the economy followed a path running generally from Northeast to Southwest, with inflation and unemployment both falling. The slight uptick of inflation from 0.3 percent in the first quarter of 2015 to 0.4 at the end of that year did not, at the time, look like a real change of direction. Viewed together with the most recent data, however, we can see that the economy’s path may have begun turning toward the Northwest as long as a year and a half ago.
In fact, for the first time in many years, the pattern is starting to look like a traditional Phillips curve, along which the inflation rate rises as the unemployment rate falls. As this earlier post explained, the Phillips curve dominated thinking about monetary policy in the 1960s and 1970s, but largely disappeared after the mid-1980s. Now it seems to be making a comeback. If we are back in a Phillips curve world, tightening interest rates now, even before inflation has hit the 2 percent target, makes more sense.
One reason for tightening now is that interest rates do not affect the economy immediately. More than half a century ago, Milton Friedman argued that monetary policy operates with long and variable lags. When asked about lags during a press conference in September of this year, Fed Chair Janet Yellen affirmed that Friedman’s view was still “one of the essential things to understand about monetary policy, and it has not fundamentally changed at all.” She went on to say that she was “not in favor of a ‘whites of their eyes’ sort of approach.” Instead, she said,
Those of us sitting around the table learned the lesson that if policy is not forward looking, inflation can pick up to highly undesirable levels, inflation expectations can be dislodged upward, and the consequence of that can be that, endemically, higher inflation takes place, which is very costly to reduce. And absolutely none of us want to relive an episode like that. And so I believe, and my colleagues, that it is important to be forward looking. We’re not going to make that mistake again. [Edited for continuity.]Market developments since the November election are a second reason why the Fed is likely to tighten sooner rather than later. Earlier in the fall, some observers had worried that a win by the unpredictable presidential candidate Donald Trump would plunge financial markets into an uncertainty-driven slump, which the Fed would hesitate to aggravate with a rate rise. Instead, the stock market has soared since the election, housing prices have firmed, and at least some of the world’s dormant commodity markets have turned upward. Warnings of potential bubbles have replaced fears of an immediate slump.
One more reason that a rate rise is likely is the expectation that a Trump presidency may shift the relationship between monetary and fiscal policy. Since the expiration of the Bush and Obama stimulus programs early in the recession, pressure from Republican deficit hawks in Congress has kept fiscal policy tight. As a result, the Fed has had to bear the entire burden of holding the economy on its path to recovery, using quantitative easing and ultra-low interest rates.
Now there is talk of massive tax cuts combined with a bipartisan agreement on an expanded program of infrastructure spending. If Congress does substantially loosen fiscal policy just as inflation and unemployment are finally reaching their target values, the Fed will have to lean hard in the other direction to maintain balance in overall macroeconomic policy.
The bottom line: No wonder observers now peg the chance of an imminent interest rate increase at better than 90 percent.
Related post: Whatever Happened to the Phillips Curve? Interpreting Half a Century of Inflation and Unemployment Data
Cross-posted from Ed Dolan's Econ Blog at Economonitor.com