Update on August 11
I wanted to add a couple charts to document the tension discussed in the text below. My timing is determined by being back at a proper computer and by the release of the jobs data and then CPI for July.
We are arguably in the range of full employment. The Blanchflower-Levin proxy takes account of the gap between the participation rate and its estimated “natural” level and the share of people working part time for economic reasons — as well as the conventional U3.
It shows we are the equivalent of about 20 bps too high on unemployment still, although easily within estimation error of “full employment.” We don’t really know, but it is no longer a no brainer that there is plenty of slack. We also don’t know about the importance of slack. Heck, there is a lot we don’t know. We used to know that there was a strong case for the Fed being dovish, although man did people deny we needed it — and believe we had it.
Based on the CPI and PPI reports for July, JPM (which tend to be good at this) estimate that the core PCE deflator will have been up about 1/2 of 0.1% during the same month. Assuming the Dallas Trimmed Mean is up a similar amount, a couple of my usual charts would update as indicated above. I show the Dallas Fed for completeness — and to tweak the hawks — not because I think Dallas has some super secret sauce. If you ignore more falling than quickly rising prices, then yeah the inflation rate recently looks marginally higher. Who cares?
Anyhow, that’s the tension, which I take a stab at trying to resolve — or figuring out how the Fed will try — below.
I noticed this week that Bloomberg Prophets published a couple pieces on the Fed’s strategy that had diametrically opposed views of the central bank’s main priority, but reflected a common desire to boil the inevitable complexity down to the one thing.
Here is Jason Schenker telling us to ignore the labor market data and to focus only on the inflation numbers, which are an indirect measure of labor market tightness anyway.
Although the July employment report was strong, it does nothing to fundamentally change the outlook for the Federal Reserve. And employment reports in future months are likely to similarly take a back seat to the most critical trigger factor for monetary policy: inflation — or lack thereof.
And here is Tim Duy, saying pretty much the exact opposite about the focus, while also insisting that the whole debate can be radically simplified:
As far as rate policy is concerned, the Fed remains fixated on the idea that the U.S. economy is near full employment. The unemployment rate currently stands at 4.4 percent, below policy makers’ median estimate of the natural rate of unemployment of 4.7 percent. Moreover, central bankers believe that the pace of jobs growth is sufficient to place continued downward pressure on unemployment, allowing them to look through weak inflation as only transitory.
(Tim reiterates these ideas following the jobs report here.)
I am no fan of the idea that we can write down a simple rule relating the optimal policy rate to some sort of weighted average of the position of the labor market and core inflation. See here, here, here, and here for my disses of the Taylor Rule and its ilk.
But, while Taylor and like are too reductionist to work in the current environment, it would seem to me to be even more unrealistic to boil the Fed’s focus down to one variable or economic condition. Instead, here is — inevitably roughly — what seems to be going on.
The Fed seems to have accepted that its earlier assessment that the labor market had effectively achieved full employment was probably premature. And I suspect they are having extreme doubts about the validity of the Phillips Curve framework itself, which is central in the Fed’s inflation forecast and in the pretense that it can manage two objectives with (let’s be honest) one instrument.
The Fed is going to let the unemployment rate drift lower until they see a response on the inflation side, whether it be in prices or maybe wages. This approach must be extremely unsatisfying to them, which — of course — they will (implausibly) describe as a “communication” challenge, to bury that they are in fact flying nearly blind. The state of the world and macroeconomics is not their fault, so they feel free to fib a bit.
Frustration and fibs aside, low inflation is making them tolerate the likely prospect of the labor market tightening to above full employment, as they estimate it. But their sense that we are probably somewhere near full employment is why tightening is even on the agenda.
Their objective right now is to slow — not reverse — the tightening of the labor market and to avoid the risk of eventually having to hit their brakes hard. Achieving this will be tricky, and may to require the funds rate to rise much. Again, see Taylor-does-not- work.
Yeah, that’s complicated, vague, hard to explain and betrays a lot of ignorance at the Fed (and elsewhere).