The Federal Open Market Committee (FOMC) meets next week – resolutely in the process of gradually removing monetary accommodation. Vice Chair Stanley Fischer, and others on the core of the Committee, argued last week that it is appropriate to set the stage for the first rate hike in eight years, which they expect in mid-2015. Indeed, data continues to strengthen and the US economy is humming along towards a fully vibrant economy. Last week’s employment report confirmed the economic strength, the tenth straight month of 200k+ private payroll growth. The market agreed, pulling in its expectation for the first rate hike to mid-2015 after the employment report.
However, despite the strength in the economy’s trajectory, the absolute level of economic strength remains below the Fed’s targets – part of the reason no one on the Committee is calling for a rate hike next week. The inflation shortfall is fairly straightforward: it’s the distance between core PCE inflation (1.55% as of October) and the Fed’s 2% target. The deviation is slightly larger if we use headline inflation, which includes food and energy, and should continue to undershoot in the medium-term given the weakness in energy prices.
The US Federal Reserve’s (Fed) “full employment” mandate is much harder to define – and communicate, fueling accusations of shifts in goalposts. The Fed aggravates the issue by not explicitly defining what they currently think the gap is, though we can implicitly estimate it based off their Summary of Economic Projections. These projections include estimates of future GDP, unemployment and inflation, along with the “dots,” the FOMC members’ estimates of appropriate policy. Given where the Fed believes appropriate policy will be, and assuming they will still follow a Taylor rule in 2015, they estimate the difference between actual and potential GDP is roughly -2%. On a $17.5 trillion economy, a -2% gap is $358 billion, or roughly annual spending on clothing and footwear in the US. A Fed report released last month using the Fed’s extensive FRB/US model of the US economy confirmed this -2% output gap.1
Calculating this gap isn’t straightforward, and disagreements do exist. The Federal Reserve Bank of San Francisco recently wrote a note on the challenge of managing to such an ambiguous target.2 For example, the Congressional Budget Office sees a 3.5% gap and the difference between the two estimates is roughly nine months vis-à-vis the first rate hike. Determining the right size of this gap – and setting policy accordingly – is immensely important to the Committee. Underestimating the gap would lead the Committee to tighten policy too soon and lock in below-trend growth, while overestimating it could result in overly easy policy and above-target inflation.3
Consequently, given where the Fed estimated the output gap to be in September, and given how data since has come in, where will the Fed place their dots next week? Since the model-oriented Committee is likely following the methodology laid out above, I expect the Committee to once again raise their 2015 dots by 10-25bps, consistent with the faster-than-expected drop in unemployment and the closing of the output gap. The Committee has signaled that they will adjust their policy trajectory based on the evolution of the data,4 which has continued to impress, so a more aggressive tightening would be appropriate.
Additionally, headwinds which have reduced both growth and the neutral Fed funds rate (the rate that is neither restrictive nor accommodative) are dissipating. These headwinds included the fiscal drag, the housing overhang, and tight credit availability which impaired the recoveries in housing and business investment. As these headwinds diminish, the neutral rate should gradually rise, and the Fed will need to raise rates in excess of this to continue removing accommodation.
The Fed’s data dependency, while at times confusing, makes for a more dynamic policy response. And before the Fed updates us on their future policy intentions next week, they’ll first need to feed their models.
1 Federal Reserve Board – Estimation of Latent Variables for the FRB/US Model
2 Federal Reserve Bank of San Francisco – Monetary Policy When the Spyglass Is Smudged
3 The Fed has weighed in on this debate, with doves on the Committee arguing that the risks associated with overestimating the gap – and running policy too easy for longer – are less than tightening earlier and calcifying high unemployment rates.
4 Federal Reserve Board – Optimal-Control Monetary Policy in the FRB/US Model