In a pure, complacent world, the Fed would be able to steer monetary policy smoothly in 2014, bring the bond purchase program to an end and "maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent." This would mean that the Fed would manage the relative flatness (forward guidance) of the money market curve in order to contain the rise of long-term yields. It would also mean that the Fed believes that the unemployment threshold below which wages or inflation accelerates is well below 6.5%.
In this complacent world, external factors would be clearly favorable to the Fed since:
i. Commodity prices (oil in particular) are expected to be flat or down slightly through the year;
ii. the odds for a strong (or at least stable) dollar remain high for 2014: Fed tapering, the positive correlation between US Treasury yields and the USD, the end of risk on / risk off which suggests that the S&P 500 can rise without triggering any decline in the USD, short rates differential with main trading partners (see chart below).
Hence, the risk of any external pass-through of external shocks to US domestic prices is very low.
If there is any risk of inflation, it has to be domestic. But it is difficult to imagine this happening, given the fact that:
i. The capacity utilization rate is still several points below its long run average;
ii. The unemployment remains high and nominal wages are growing at a pace below or close to the troughs of previous recessions (see below).
This should quell any fear of having the Fed behind the curve in 2014. In addition, based on the measure of the Shadow Rate (see here), the current stance of monetary policy is too accommodative (difference between the Taylor rule implied Fed Funds rate and the shadow rate).
In addition, the Fed has expressed some concerns over the falling pace of productivity gains recently.
Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped….. The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms, or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement…/.. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth. (Bernanke, January 3, 2014).
There are long run implications if the fall in productivity gain is secular. But the short run matters too, as inflation is directly linked to the difference between wage growth and productivity gain, which is the definition of unit labor cost. As can be seen below, core inflation tends to accelerate when unit labor cost is growing.
The disconnect observed above calls for a correction. Will it happen through:
i. further pressure on wages, which would be detrimental to the recovery?
ii. an incentive for businesses to invest more and increase productivity per capita (the balanced recovery assumption)?
iii. An increase in core CPI inflation, putting at risk the Fed's rhetoric on the inflation risk? This cannot be ruled out.
Bottom line: the odds clearly remain in favor of a tame inflationary backdrop through 2014, especially since the risk of imported inflation shock remains limited. Yet, if the tapering is not enough to significantly reduce the abundance of monetary policy accommodation over the next few months (increased shadow rate), the Fed might fall behind the curve, as the productivity slowdown should not be thought of only as a long run issue.
The widening gap between the expectation of the first rate hike by primary dealers (Q4 2015) and when the Fed is expecting the unemployment rate to breach the 6.5% threshold (Q4 2014) increases the risk for the Fed to be seen as behind the curve.
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