When Federal Reserve chairman Jay Powell strode into Congress this week to give evidence on US monetary policy, his extremely dovish tone changed the terms of the debate about what the central bank will do next.
Most investors stopped wondering whether precautionary “insurance cuts” in rates will be announced in July and September. That is now seen as highly likely. The new focus is on whether the Fed might embark on a more fundamental change in policy rates and the monetary policy framework. The ground could be shifting at the Federal Open Market Committee.
The publication on July 5 of the Fed’s biannual monetary policy report is a good opportunity to analyse the views of the Fed’s economic staff on the central bank’s strategy.
The report contains an interesting update on the Fed’s use of monetary policy rules to inform its thinking on interest rates (see below). Although the FOMC does not mechanically adopt the recommendation from any single rule, collectively they are used to provide an indication of “appropriate” policy, based on current economic conditions.
Four of the five rules included in the latest report are based on different forms of the standard Taylor rule that is often used to inform monetary policy. They indicate that the appropriate level for policy rates is in the range 2.0-3.5 per cent, which implies that the current Fed funds target of 2.25-2.50 per cent is about right, or even too easy, given today’s inflation and unemployment rates, and the latest estimates for equilibrium interest rates in the economy.
On the face of it, these rules therefore offer little or no support for a rate cut in the near future. However, there are reasons to think the FOMC may take a more dovish view.
The report states that, at times, the balance of risks to the outlook may justify a policy response different from that implied by the most likely out-turn for the economy. This is significant, given that the FOMC is obviously considering an insurance cut in rates for exactly that reason.
How large might such an insurance cut prove to be?
Fed vice-chair Richard Clarida has implied that the current situation is similar to that in 1995 and 1998; on both occasions the Fed cut rates by 75 basis points. However, as Jan Hatzius of Goldman Sachs has argued, these two episodes differed from now, because real rates and financial conditions were considerably tighter when the uncertainty shocks hit the economy. In present conditions, a maximum of 50 basis points in cuts seems justified, in my view, if the reasoning is confined strictly to insurance against recession.
The market is expecting the cumulative cuts by the end of 2020 to be almost twice as large as these insurance cuts. It is possible that investors fear the uncertainty created by the trade wars will have a much more persistent effect on business investment and economic activity than the initial shocks. Under questioning, Mr Powell strongly agreed that this was a concern.
In addition, there are signs that the FOMC’s thinking on inflation is changing. The committee still expects inflation to return to target in the medium term, and in the report continued to describe the recent shortfall in inflation as “transitory”. However, the chairman himself dropped the word “transitory” from his written evidence and vehemently rejected suggestions that the labour market is overheating.
Mr Powell is also concerned that the current policy framework is producing a bias towards shortfalls in inflation relative to the central bank’s symmetrical 2 per cent inflation target, or an alternative target based on the price level rather than inflation.
Significantly, the Fed chose to include a price level rule in its report, using 1998 as the base date for calculating the target. This is an aggressive target, because it implies that any shortfall below a 2 per cent a year cumulative path for prices over the past two decades should be reflected in lower policy rates. The report concludes that interest rates should now be around zero to compensate for a long period in which prices have risen by less than 2 per cent on average.
It is possible that such a price level rule, although not yet officially adopted by the Fed in its ongoing review of the policy framework, is beginning to influence the thinking of some FOMC participants, including the chairman.
If so, the committee’s appetite for rate cuts may extend considerably further than the 50 basis points required to take out an insurance policy against recession.
The Fed’s Taylor rules and the price level rule
The Fed’s monetary policy report, published on 5 July, shows “appropriate” policy rates derived from several different rules that are scrutinised by the FOMC. Four of the five published rules suggest that the current policy rate should be in the range 2.0-3.5 per cent, which is close to or above the 2.25-2.50 per cent target for the federal funds rate.
Only one rule suggests that large cuts in the policy rate are now appropriate. This is the “price level” rule that requires the central bank to maintain lower rates for a long period to make up for the undershoot in the price level, relative to a 2 per cent target path, since 1998. On this rule, policy rates should now be around zero:
The report’s version of a price level rule uses the gap between the core personal consumption index (PCE) and a 2 per cent target path since the 1998 base date. At present, the price level is about 6 per cent below target, which is why the indicated policy rate on this rule is so low:
An alternative definition, using headline PCE instead of core, reduces the gap slightly, but this still indicates an appropriate policy rate close to zero: