BERKELEY – In December 2015, the US Federal Reserve embarked on a monetary-tightening cycle, by raising the target range for the short-term nominal federal funds rate by 25 basis points (one-quarter of a percentage point). At the time, the Federal Open Market Committee (FOMC) – the Fed body that sets monetary policy – issued a median forecast predicting three things.
First, the FOMC indicated that the December 2015 rate increase would be the first of five such increases that it would make within the subsequent year, and the first of nine that would take place by, say, September 2017. Second, the federal funds rate would reach 2.25-2.5% within three months of the December 2015 increase. And, third, the Fed’s preferred measure of inflationary pressure – the core personal consumption expenditures (PCE) price index – would be at 1.9% per year by now.
All told, the FOMC’s forecast has not been borne out. If the Fed actually does increase interest rates this month, it will have undertaken only four of the nine anticipated rate hikes. Moreover, it believed that nine rate hikes before the end of this summer would be necessary to keep inflation below its target of 2% per year. But inflation is expected to rise at an annual rate of just 1.5% for the rest of this year, and next year.
In terms of inflationary pressure, the Fed’s forecast seems to have significantly overstated the strength of the US economy. Even with the Fed’s change of course (it is now pursuing a federal funds rate that is 1.5 percentage points below its December 2015 plan), inflationary pressure is still relatively weak. Indeed, despite the economic boost implied by slower policy tightening, the rate of inflation is still no higher than it was in the 2013-2014 period, when many worried that the Fed wasn’t providing enough stimulus.
We can draw three conclusions about the current situation. First, today’s weak inflation outlook suggests that the Fed’s monetary policies, in combination with fiscal policies, are not providing sufficient stimulus for the US economy – as was the case in 2013. Unfortunately, the FOMC does not appear to be particularly concerned about this possibility. Among FOMC members, Neel Kashkari, the impressive president of the Federal Reserve Bank of Minneapolis, is the only one who has dissented, calling on the Fed to pursue more stimulative policies.
The FOMC’s blind spot stems from the fact that it is relying more on its assessment of the labor market, which it considers to be at or above “full employment,” than on noisy month-to-month inflation data. But “full employment” is a rather tenuous and unreliable construct. It has now been 20 years since economists Douglas Staiger, James Stock, and Mark Watson showed that Fed policymakers should not be so confident in estimates of “full employment.” And yet, for some reason, the Fed community has not let this essential message sink in.
A second conclusion to be drawn from the current situation is that the Fed has now overestimated the strength of the US economy for 11 consecutive years. Elementary mathematics dictates that credible forecasts should at least overestimate half the time and undershoot half the time. If each year of Fed forecasting were a coin toss, we would now have had eleven heads in a row, and zero tails. The odds of that happening are one in 2,048.
The Fed clearly needs to take a deep look at its forecasting methodology and policymaking processes. It should ask if the current system is creating irresistible incentives for Fed technocrats to highball their inflation forecasts. And it should ensure that its policymakers view the 2% target for annual inflation as a goal to aspire to, rather than a ceiling to avoid.
A final conclusion is that the past two years have provided still more data to support former US Secretary of the Treasury Larry Summers’ grave suspicion that the economies of the global North are now trapped in a state of “secular stagnation.” Those who disagree, such as Kenneth Rogoff of Harvard University, tell us that all will soon be well, and that nobody will be talking about “secular stagnation” eight years hence. They may turn out to be right – but only if the Fed can bring itself to pursue stimulus policies that are as radical as they are necessary.