Economic Outlook by Alan Blinder
Alan S. Blinder
Vice Chairman and Co-Founder, Promontory Interfinancial Network
Professor of Economics and Public Affairs, Princeton University
We learned something important on Wednesday: we have a more dovish Federal Open Market Committee (FOMC) than we knew. That’s highly relevant as we peer into a future in which the federal funds rate will gradually rise at some unknown pace. If you were worried that the Fed would take rates up too fast, you should relax. If you were worried that the Fed would be too slow on the draw, you should fret even more.
Going into the March 15 - 16 meeting, there was both a plausible dovish case (leading to the expectation of no more than 50 bps of tightening in 2016, maybe less) and a plausible hawkish case (leading to the expectation of 75 bps of tightening, maybe more). Let’s review the essence of these two cases.
With wages showing only weak signs of acceleration, doves believe there is still a fair amount of slack in the U.S. labor market despite the 4.9% unemployment rate. Implicitly, the doves must also believe that net job creation can continue at or near its recent pace (235,000 per month over the past six months) for some time yet, even though “trend” growth these days is more like 80,000 - 90,000 jobs. Some doves——most prominently, Governor Lael Brainard——have been emphasizing the weakness the U.S. economy might import from abroad. There are also dangers that financial markets, addicted to super-low interest rates for years, might suffer severe withdrawal symptoms.
The hawks look at the same labor market data and see slack as already gone or disappearing quickly; they read the hints of wage acceleration as confirming that view. The hawks have also noticed, to put it mildly, the recent upticks in inflation. Implicitly, they also worry less about the dangers from abroad and from financial markets. Perhaps most fundamentally, the inconsistency between a federal funds rate near zero and an economy at or near full employment gives hawks profound headaches.
Prior to the latest meeting, we knew that this debate raged inside the FOMC (notice that Esther George of the Kansas City Fed dissented) and even within the Board of Governors itself (contrast the dovish sentiments from Brainard with the more hawkish commentary from Vice Chairman Stanley Fischer). What we learned on Wednesday is that the dovish faction is firmly in control, at least for now.
In her press conference, Chair Janet Yellen explicitly endorsed the view that slack remains in the labor market, pointing to minimal wage pressure as evidence. (Consistent with that, the FOMC lowered its estimate of the so-called natural rate of unemployment.) She also questioned the staying power of recent increases in core inflation. She chose Brainard over Fisher, if you will.
Perhaps most surprisingly, at least to me, the FOMC statement emphasized “global economic and financial developments” as major downside risks. Yes, such risks are present, though I think the Fed gives them too much weight. But the big surprise was the strong spotlight the FOMC shined on them.
Recall that the FOMC had surprised a lot of people in September 2015 when it included the following sentence in its statement: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” These words were widely translated as: we can’t raise rates while there are ructions in China and a sagging U.S. stock market. So when the FOMC statement dropped this sentence entirely the very next month, many observers concluded that the Committee saw it had made a mistake in September and rectified it in October. Apparently not.
The main concrete news the FOMC delivered on Wednesday was that it was reducing its projected tightening during 2016 by 50 basis points relative to its December projection. Most observers, including yours truly, had expected only 25 bps. (Yes, a 25 bp difference is a big deal in this context!)
It’s true that the Fed downgraded its near-term forecast a bit, but not enough to rationalize a 50 bp change in monetary policy. So maybe the market pessimists convinced the Fed——or scared it. Or maybe the FOMC majority has decided to run another 1996-style experiment to see how low the unemployment rate can go without raising inflation. Or maybe both. We’ll see.