The September SEP showed upward revisions to the path of the FF rate and the unemployment rate. The new projection for core PCE price inflation is close(r) to the model-based forecast in 2023 but well below it in 2024 and 2025. In other words, the FOMC continues to project a quasi-immaculate disinflation (hoping supply will help is not a strategy). Nevertheless, the new projections show a 6 tenths increase in the unemployment rate. In other words, the FOMC has finally admitted what the models have been saying for months: disinflating the US economy will probably require a very aggressive monetary policy followed by a recession. Indeed, according to the models, bringing down inflation by 2024 would require pushing the FF rate (the unemployment rate) above the 4.6% (4.4%) of the September SEP.
To sum up: the FOMC made a step in the right direction but there is more work to be done.
SEP forecast
Probably the most important news (on the inflation front) in the newly released SEP is the upward revision of the 2023 core PCE price inflation forecast. The median is now at 3.1% (from 2.7%) with a visible increase of the bottom of the distribution. For the record, our “main” model is currently forecasting 3.5% in 2023. At the same time, the FOMC left unchanged its 2024 forecast to 2.3% (while our “main” model is at 3.2%).
The FOMC continues to forecast an immaculate disinflation (the models, in fact, suggest that the unemployment rate consistent with the SEP inflation forecast is higher than the one in the SEP). But at least the FOMC has admitted that the information received points to a more persistent process than previously anticipated.
Q&As
How will you know when to stop hiking?
Powell: “I will answer your question directly but I want to start here today by saying that my main message has not changed at all since Jackson Hole. The FOMC is strongly resolved to bring inflation down to 2% and we will keep at it until the job is done. So the way we’re thinking about this is the overarching focus of the committee is getting inflation back down to 2%. To accomplish that, we think we’ll need to do two things, in particular to achieve a period of growth below trend and also some softening in labor market conditions to foster a better balance between demand and supply in the labor market. […] We think that we’ll need to bring our funds rate to a restrictive level and to keep it there for some time. So what will we be looking at I guess is your question so we’ll be looking at a few things: first we’ll want to see growth continuing to run below trend, I want to see movements in the labor market showing a return to a better balance between supply and demand and ultimately we’ll want to see clear evidence that inflation is moving back down to 2% so that’s what we’ll be looking for in terms of… of reducing rates. I think we’d want to be very confident that inflation is moving back down to 2% before we would consider that”.
Comment: Nobody knows what is the level of the FF rate needed, although we do have an idea based on the general equilibrium models. At this point, the Fed staff and the FOMC will need to see some convincing moderation in the data before changing their minds. And they will not stop, not even in case of soft economic data. Indeed, the Fed needs such a slowdown. Of course, there is a risk that the Fed will end up overdoing it. But in this environment, doing too much is way better for the Fed than doing too little.
Will you increase rates “linearly” or do you envision a pause at some point?
Powell: “What we think we need to do and should do is to move our policy rate to a restrictive level that’s restrictive enough to bring inflation down to 2% where we have confidence of that. What you see in the SEP numbers is people’s views as of today, as of this meeting as to the kind of levels that will be appropriate. Now, those will evolve overtime and I think we’ll just have to see how that goes. I think there is a possibility they would go to a certain level that we were confident and stay there for a time but we’re not at that level clearly today, we’ve just moved I think probably into the very lowest level of what might be restrictive. And certainly in my view and the view of the committee there’s a way to go.“
Comment: Powell is onboard. He knows that disinflating requires positive real rates for a protracted period of time. Of course, the Fed does not know exactly for how long they will need to keep the FF rate elevated. The data will tell us. But they are very committed and they will deliver.
The unemployment rate at 4.4% is historically associated with a recession. Is that what it will take to disinflate?
Powell: “We see the current situation as outside of historical experience in a number of ways and I’ll mention a couple of those. First […] job openings are incredibly high relative to the number of people looking for work. It’s plausible, let’s say, that job openings could come down significantly without as much of an increase in unemployment as has happened in earlier historical episodes; in addition, in this cycle longer run inflation expectations are have generally been fairly well anchored and I’ve said there’s no basis for complacency there but to the extent that continues to be the case that should make it easier to restore price stability. And I guess the third thing I would point to that’s different this time is that part of this inflation is caused by this series of supply shocks that we’ve had beginning with the pandemic and rolling with really with the reopening of the economy and more recently amplified and attitude by Russia’s invasion of Ukraine have all contributed to the sharp increase in inflation. These are these are the kinds of events that are not really seen in prior business cycles and in principle if those things start to get better […] could help ease the pressures on inflation”
“We don’t know, no one knows whether this process will [require a] recession or if so, how significant that recession would be. That’s gonna depend on how quickly wage and price inflation inflation pressures come down, whether expectations remain anchored, and whether you know also do we get more labor supply which would help as well in addition the chances of a soft landing”
Comment: Whether a 4.4% unemployment rate is historically associated with a recession is irrelevant for the Fed right now. The big message, instead, is that they are willing to tolerate it. In other words, in their reaction function (Taylor rule) the weight of the unemployment gap has probably gone down. Our simulations show that conditional on their degree of inertia, lowering the labor market coefficient to zero (that is, pushing the FOMC to the ECB-style) increases the peak of the FF rate to 5%-ish. In other words, the new SEP show a higher terminal rate but in principle there is room for additional upward revisions.
Why do you keep front-loading?
Powell: “If you look at […] this year’s inflation, 3-6-12 month trailing you see inflation is running too high… it’s running 4.5% or above. You don’t need to know much more than that. That’s the one thing you know, you know that this committee is committed to getting to.. you know.. meaningfully restrictive stance of policy and staying there until we feel confident that inflation is coming down”
Comment: We are not surprised. The distribution of core PCE price changes is possibly the most important indicator you should look at. And there is really no sign so far of any downward movements.
Several central banks around the world are tightening. Is there a risk of over doing it (recession) at the global level?
Powell: “We are very aware of what’s going on in other economies around the world and what that means for us and vice versa. The forecast that we put together, our staff puts together and that we put together on our own always take all of that… try to take all of that into account. I mean, I can’t say that we do it perfectly but it’s not… it’s not as if we don’t think about the policy decisions […] are taking place in major economies that can have an effect on the US economy. That is very much baked into our own forecast.”
Comment: The Fed staff forecast considers what happens in the rest of the world, of course. What Powell did not mention, however, is that the sensitivity of US inflation to economic conditions abroad is low. The main passthrough is through the US dollar, but even in that case the elasticity is quite low (10% increase in the broad dollar results in about 3 tenths on core PCE price inflation). So overall, we think that the FOMC is aware of what happens abroad but remains very much focused on the US economy.
Is there a short-run trade-off right now between price stability and full employment?
Powell: “What we’re hearing from people is you know very much inflation is really hurting. So how do we get rid of inflation? As I mentioned, it would be nice if there were you know a way to just wash it away but there isn’t. We have to get supply and demand back to alignment. The way we do that is by slowing the economy. Hopefully, we do that by slowing the economy, we see some softening in labor market conditions, a big contribution from supply side, you know… improvements and things like that, but none of that is guaranteed. In any case, our job is to deliver price stability and I think you can think of price stability as an asset that just delivers large benefits to society over a long period of time.“
Comment: There you have Powell’s commitment. Maybe the Fed will get lucky and it will be helped by supply. But the baseline remains the same: they need to slowdown demand significantly from here.