Low unemployment and “the curve”

A continued steep decline of the headline unemployment rate and corroborating evidence from alternative measures of labor market slack have convinced some analysts that the cautious Fed may be falling “behind the curve.”  You can see here and here for two very similar examples from Bloomberg. (In fairness to Tim Duy, he wrote his take first.)  But I am sure you are familiar with the idea.

There is a reasonable debate, I think, about what is meant by “full employment” and how that links to the inflation outlook and what the Fed should do. For whatever it is worth, I don’t hate the idea of full employment, and think it may be a relevant concept even if the Phillips Curve is flat or non-existent. That is a separate discussion.

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But for the sake of argument, let’s take it as a given that the Fed will want to ration demand growth down to (supply-side) potential once the economy has hit full employment.  For good or ill, the Fed leadership leaves every impression that they intend to do that.  Either way, at some point, the unemployment is going to (have to) stop falling. That is definitionally true, although we can quibble about where some point is.

To me, that simple point comprises the germ of truth in the idea that the lower unemployment will force the Fed speed up its tightening. But it is only a germ.  The idea that the appropriate level of the funds rate – and thus the speed of tightening – correlates reliably with the unemployment rate is not supported by the evidence or even logic.

Who knows? Maybe demand growth will cool on its own, as pent-up demands get exhausted or wealth effects eventually dissipate. I would not bet on this result in fixed income, because the forward curve is pretty flat  and does not spot you much.   But, again, that is a separate discussion.

The idea that the appropriate (real) funds rate correlates reliably negatively with the unemployment rate is a vestige of the Taylor Rule.  I explained here my take on why the Taylor Rule and similar reductionist approaches to monetary policy cannot work in the neighborhood of the zero bound.   In my view, the gist is:

Crucially, the Taylor Rule does not identify the level of the funds rate appropriate to the current position of the business cycle. It would be a bizarre coincidence, as Dudley emphasizes, if the funds rate exactly appropriate to today could be described as a linear combination of the unemployment rate (or output gap) and the inflation rate.  

… No, the key feature of the Taylor Rule is that it incorporates stabilizing feedback signals that allow it to perform well in most economic environments (at least as simulated by econometric studies) despite its failure to identify the appropriate level of the fund rate in real time (which would be impossible).

For example, if the Taylor Rule were to prescribe a funds rate of 4%, and if that turned out to be too restrictive, then the following sequence of largely-benign events would arise.   The economy would slow in an undesired way and either the unemployment rate would rise or the inflation rate would fall. This would be recognized by the Taylor Rule as a signal that easier policy was required.

… However, none of that (is operational) in the current environment, which is why following the Taylor Rule or allied approaches is ruled out.  Right now, the Fed needs to make a judgment call on how its rates policy path will affect the economic outlook and cannot rely on the central feature of the Taylor Rule, which is that mistakes are easily corrected. This is admittedly a sticky situation to be in. I do not envy them.

Unsurprisingly, then, the Fed has not been following a zero bound for the past decade, and not just because it has been technically difficult to deliver a negative funds rate.  The timing and pace of “liftoff” should also vary from Taylor Rule prescriptions when the zero bound is proximate, for reasons Ben Bernanke alludes to in his most recent blog post, although a bit elliptically.

Screen Shot 2017-05-11 at 4.41.16 PMTake a look at the chart above.  The top panel is from an earlier Bernanke post in which he argues that the Fed at least implicitly followed a “balanced” Taylor Rule during the 2000s. Bernanke’s point is not that the Taylor Rule is a godsend but that – demonstrably – following a version of it would not have prevented the bubble.  In that chart, Bernanke uses data that was available to the Fed in real time, as is appropriate to his purpose.

The lower panel of the chart just updates the same Taylor Rule to today, although using data available only now, and at a monthly rather than quarterly frequency. I use Bernanke’s strange green and try roughly to overlay the date ranges, which is why the chart at bottom is wider. That construction allows you to see the effects of the revisions, although that is incidental, as my use of current-vintage data is mostly about data constraints (on me) and laziness.

Anyhow, the Fed has not been following even a dovish parameterization of the Taylor Rule, even as the zero bound has not been strictly binding.   The issue with the zero bound is that it is proximate, not currently binding, as I explained in my original post.

Janet Yellen has argued, incredibly to me, that the Fed is following the logic of policy rules but is aware that the coefficient on the output gap may vary, along with the equilibrium real interest rate or even extent of “inertia” in the actual policy rate. I think I know why she chose to do this. She wants to ward off the threat Congress might impose  that the Fed make at least some reference to the Taylor Rule in setting policy.

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Her point to Congress is that the Fed of already are following Taylor or the like. But that is marketing BS. If you can tweak the variables and even add new terms, then you are following discretion and not Taylor.  Which is good, in the current circumstance. But that goodness is separate from the deception involved here.

When the zero bound is proximate, the Fed simply cannot follow the logic of the Taylor Rule. And I would say that as an extension of that there is no reliable negative correlation between the unemployment rate and the (real) fed funds rate that the Fed will or should deliver.  I mention this not to be dovish.  The forward curve spots you so little.  Rather, this is just leaning into a quite conventional take that seems wrong.