A Simple Framework for Understanding Fed Views on the State of the Economy

by: Tim Duy

It is worthwhile to construct a simple framework to place into context the various Federal Reserve views on the state of the economy. Via that framework, we can at least keep clear whose bread is buttered on which side.

Begin with a basic AS-AD model:

ASAD1I illustrated sort-run aggregate supply as kinked, with the horizontal portion reflecting sufficient excess capacity that prices hold constant across a range of output. This is not strictly necessary for a simple framework, but reflects the general impression that the threat of deflation was quickly replaced with inflation concerns. Also, I understand that a model in levels is not exactly ideal for considering inflation dynamics, but I also think we can see through to the general implications for inflation and policy. Consider an increase in aggregate demand:

ASAD2

Whatever you think of the nature of the recovery, there appears to be general agreement that some recovery is in place, what the Fed describes as “firmer footing.” The pace of job creation in the last six months appears consistent growth a little above trend. I think we can consider this improvement as a general increase in aggregate demand.

Note what occurs once demand rises sufficiently to pull output past the “kink” in the short run aggregate supply curve – there is suddenly room for upward pressure on prices. This appears consistnet with the general shift in risk away from deflation toward inflation. The situation could be somewhat more complicated if supply issues, particularly for oil, are putting upward pressure on the long run aggregate supply curve at the same time, but for the reasons below this also does not need to impact our long run inflation story.

Importantly, we need to expect such pressure to continue as the price level rises until output was consistent with potential. In short, the rising prices can coexist with large output gaps. How does this translate into likely the likely path of inflation? The way I think about it is that prices return to their prerecession trend:

Corepce

This implies that reestablishing long-run equilibrium entails a period of relatively higher inflation. And that inflation will create significant unease among a certain group of policymakers (and investors, for that matter). Dallas Federal Reserve President Richard Fisher:

We know from anecdotal soundings that American businesses, like businesses in other countries, are doing their utmost to offset with higher prices the surging costs of inputs such as fuel, other commodities and materials, and components, parts and processes sourced from abroad. My gut tells me that this will result in some unpleasant general price inflation numbers in the next few reporting periods…

I am not sure that we can reestablish potential output without enduring this uncomfortable period. Policymakers and investors need to look through this period to the other side; they need to be thinking about where inflation expectations will be once that equilibrium is reestablished. Federal Reserve Governor Janet Yellen:

…in light of the experience of the 1970s, it is clear that we cannot be complacent about the stability of inflation expectations, and we must be prepared to take decisive action to keep these expectations stable. For example, if a continued run-up in commodity prices appeared to be sparking a wage-price spiral, then underlying inflation could begin trending upward at an unacceptable pace.

Note specifically the issue of a wage-price spiral. Those who argue that the current dynamics will lead to only a temporary inflation increase believe slack labor markets greatly reduce the risk of wage gains – inflationary or not! Without wage inflation playing a supporting role, it is difficult to see that any increase in inflationary expectations can be sustained. Even inflation hawks seem to recognize this. Back to Fisher:

Given that we still have significant excess capacity of unemployed workers, extremely subdued wage growth, strong productivity growth and weak domestic demand, one might reasonably posit that the general inflationary pressures we are experiencing presently are transitory…

What we should expect is that inflation accelerates for a period of time as the economy shifts back toward potential, at which time, assuming monetary policy is appropriately moderated in the background, we would expect inflation to decelerate back around the Fed’s target of around 2%. Inflation followed by disinflation.

The next debate is the issue of how soon the Fed needs to be acting to ensure that policy is appropriately moderated. Broadly speaking, there are two views on this point, and it basically comes down to an empirical question – has the rate of structural unemployment risen? If not, we are far from potential output as there is plenty of involuntarily un- and underemployed labor to be reintegrated back into the economy, in which case we have little reason to expect that wage gains will accelerate rapidly and thus threaten a wage price-spiral. But, as Yellen notes, we should be mindful of this issue, and be open to the possibility that structural unemployment has risen.

Indeed, perhaps the economy underwent an alteration in the few years such that a significant portion of the population lack a required skill set. Construction workers, for example, given that housing demand is likely to look different in the future. A rise in structural unemployment can be graphically illustrated as a leftward shift of potential output:

ASAD3Under such conditions, the economy is closer than we imagine to potential output, and thus the risk of overshooting and triggering a wage-price spiral is quite high. This seems to be what Fisher has in mind when he follows up the previous earlier quote with:

…Nonetheless, adding still more liquidity, or not withdrawing in a timely manner what we already provided in abundance, would do nothing to quell emerging inflationary pressures and might well compound them, proving doubly injurious to savers and the earnings of those who do have jobs...

and:

Now, we at the Fed are nearing a tipping point. Just as we pressed on in doing our duty through extraordinary, exigent measures, we must now discipline ourselves to just as persistently normalize our operations in a timely way.

Fisher appears to take a potential increase in structural unemployment as fact. As Brad DeLong points out, Minneapolis Federal Reserve President Narayan Kocherlakota estimates that structural unemployment has risen as much as 3%, which would put the natural rate at 8%. David Altig suggests an increase as much as 1.7%. Again, this is an empirical question, and I would argue that rising joblessness across a broad range of sectors coupled with nonexistent wage pressures suggest that structural unemployment has not increased much at all, and even if it has, we still need to recognize the likelihood that a strengthening economy will increase labor force participation such that unemployment will cotinue to fall at a slow pace. Moreover, this was the anecdotal story via the most recent Beige Book:

Manufacturing and retail contacts across Districts reported rising input costs. Manufacturers in many Districts conveyed that they were passing through higher input costs to customers or planned to do so in the near future...There is little evidence of wage pressures across Districts. Wages remained steady in the Boston, Philadelphia, Cleveland, Kansas City, and Dallas Districts, while moderate wage pressures were reported in the Chicago, Minneapolis and San Francisco Districts. Philadelphia, Dallas, and San Francisco noted that most wage increases were for workers with specialized skills.

I would also note this is the view of consumers themselves, from the Reuters/University of Michigan survey March press release:

Just one-in-four consumers expected their financial position to improve during the year ahead, returning to near the lowest level ever recorded of 20%. Scarce income gains as well as rising food and gas inflation were responsible for these dismal financial expectations. Only 38% of all households expected income increases in the year ahead, the smallest proportion ever recorded. Just 11% of all households expected inflation-adjusted income gains during the year ahead, barely above the all-time low of 8% in 1980.

Overall, incoming data appear consistent with a view that we are far from a point at which a wage-price spiral should be a concern. If so, then tightening policy in response to either higher commodity prices and general economic improvement risks confusing a relative price change or an return to potential output as in and of themselves capable of triggering a wage-price spiral. Instead, the economy would be then needlessly mired at suboptimal point, in which case disiniflationary expectations may once again assert themselves. New York Federal Reserve President William Dudley reflects upon this issue and concludes:

“We’re probably going to have excess slack in the U.S. labor market at least through the end of 2012, and that’s one reason that colored my view that we shouldn’t be overly enthusiastic about tightening monetary policy too early,” Dudley told a forum in Tokyo today.

Interestingly, Fisher recognizes that the data gives no indication of an impending wage-price spiral, that data apparently has no impact on his thought process. He instead goes to the rest of the world:

There is the risk that we might breach our duty to hold inflation at bay. Inflationary impulses are gaining ground in the rest of the world. At the core of the euro zone, Germany, where unemployment is actually lower than before the crisis, wage inflation is pressing up against 3 percent. Retail price inflation in the United Kingdom now exceeds 5 percent, despite very high unemployment. Reported inflation now exceeds 4.5 percent in China, 6 percent in Brazil and 8 percent in India.

It is far from clear that Europe as a whole needs tighter policy (the opposite is more likely), so Fisher drills down to Germany, but doesn’t seem to recognize that the he undermines his own argument as unemployment is nowhere near the pre-crisis level in the US. Moreover, notice his horror that wages in Germany may rise 3%. 3% - it is an apocalypse! How much of this could be accounted for by productivity growth? What is happening to unit labor costs? Then he proceeds through a litany of inflation rates in the rest of the world as if these should be meaningful to US policy. I guess he needs them to be relevant as the US data to support his view is lacking. It is this attitude that concerns me; that the actions of the past three years must lead to runaway inflation is taken as an article of faith by some, rather than a topic of serious research and analysis.

Bottom line: We can track the path of the prices and output and explore the positions of Fed officials within a fairly simple framework. That framework suggests that the economy will experience a temporary period of accelerating inflation as it returns to potential (we should be so lucky, quite frankly). There doesn’t seem to be much debate at what speed this will occur; Fed officials appear comfortable with growth expectations around 3.7% this year.

What does seem to be an issue of debate is the size of the unemployment gap. If we are close to the natural rate of output, excess monetary stimulus is close to triggering the fabled wage-price spiral. If far, there is plenty of excess capacity and thus no need to tighten quickly. Indeed, tightening policy too soon would only entrench disinflationary expectations.

Fed officials appear to be splitting along these two basic views of the world, with one side seeing recent price increases as consistent with their inflationary nightmares. I tend toward the other, which I also think will be the dominate view at the FOMC. But keep an eye on the wage/compensation type data – the FOMC doves are doing the same.