Over at Project Syndicate, Brad DeLong takes issue with Fed policy decisions. Importantly, he identifies, correctly, that the Fed's forecasting record in recent years has been less than optimal. Much less. The repeated optimism that inflation will soon revert to target is a most significant problem for a central bank with a formal inflation target. On this point, the Fed has faced disappointment time and time again.
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Brad is correct in his summary that the Fed needs to reassess its forecasting methodology to ensure that it is not biased toward high inflation forecasts. That said, I believe the issue is not quite as severe as Brad believes. In particular, I think this may be a bit unfair:
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.
I think there is actually quite a bit of uncertainty among Fed officials about the exact level of full employment. To be sure, policymakers repeatedly argue that they believe they are near full employment. But first, take that into the context of changing estimates of full employment:
Clearly, policymakers are willing to change their minds as new information becomes available.
Second, if they were fairly inflexible regarding their estimates of full employment and the implications for inflation, they would have raised rates after unemployment fell to 6.5% - the threshold for maintaining zero rates under the Evans Rule.
Third, and probably most importantly, if they clung to a strict confidence in their estimates of full employment, they would have long ago abandoned their gradual approach to raising interest rates. As of now, the unemployment rate at 4.3% is a full 0.4 percentage points below the median estimate of the longer-run unemployment rate and below the 4.5-5.0% range of estimates of that measure. Moreover, job growth remains strong enough to drive the unemployment rate further down. So if they were very confident of their estimates of full employment, Fed officials would be much more concerned that they had already fallen behind the inflation curve. They would be raising rates at every meeting, not just an expected three times this year. They wouldn't be dragging their heels on raising interest rates back to their estimate of neutral. They would be racing to do so.
The unemployment rate in May stood 0.5 percentage points below the January level. At this pace, the rate will fall below 4% by the end of this year. That is not unreasonable at this point. Yet policymakers largely continue to expect just two more rate hike this year - which I find incredibly patient given that I doubt there is any FOMC participant who believes that inflation can remain contained if the unemployment rate holds consistently below 4%.
Fourth, recall the conclusion of Federal Reserve Governors Lael Brainard's recent speech:
While that remains my baseline expectation, I will be watching carefully for any signs that progress toward our inflation objective is slowing. With a low neutral real rate, achieving our symmetric inflation target is more important than ever in order to preserve some room for conventional policy to buffer adverse developments in the economy. If the soft inflation data persist, that would be concerning and, ultimately, could lead me to reassess the appropriate path of policy.
I take this at face value - the Fed will likely reduce the path of expected rate hikes if inflation does not firm in the next few months.
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Finally, I understand the hesitancy to raise rates in the face of low inflation. I too have an innate desire to hold back policy until we see the "whites in the eyes" of the inflation beast. But I also understand the position of policymakers - the uncertainty cuts both ways. There is a chance that the Phillips curve is nonlinear and the economy is close to an inflection point. And if that inflection point hits, they don't have confidence they can easily slow the economy without triggering a recession. So, from their perspective, restraining the economy a notch now may maximize the net present value of output if it prevents a recession later.
Bottom Line: The Fed's gradual, data-dependent path is almost perfectly designed to make no one happy. Too slow for some, too fast for others. Perhaps that means it is more right than wrong after all.
