Fed Policy Takes Another Walk On The Wild Side

by: Robert Brusca

The Federal Reserve has adopted a new policy of focusing on the headline PCE deflator instead of the core. The PCE is the price index used to account for inflation in the personal consumption expenditures index, the broadest index of consumer spending. The Fed has issued a special policy document that describes how it will engage its duties under the dual mandate framework. Despite this policy statement, a lot about how the Fed will conduct itself remains steeped in mystery.

The Fed has clearly stated that its notion of price stability under the dual mandate is the headline PCE at 2%. The Fed directs us to look at the Year/Year PCE. Rounding out its dual mandate the Fed refuses to put up a growth or unemployment target but it does issue periodic 'forecasts,' which give us an idea of the path and range for unemployment that the Fed now thinks is most consistent with its mandate and with economic realities. But while its inflation focus is clear its unemployment focus is not and is subject to change.

Despite this elucidation, the Fed has not been able to dispel the inherent contradiction in the dual (dueling?) mandate.

(Click chart to expand)

The chart above compiles a set of actual data to illustrate the Fed's policy dilemma. We retro fit the Fed's new rule to the past PCE, and U-rate with both slightly transformed and plotted against the actual Fed funds rate. The Year/Year PCE is plotted with its mandate value (2%) subtracted from it. The actual historic U-rate is plotted with the Nairu rate subtracted from it. Thus each Fed mandate series is plotted at a deviation from its desired value. We use NAIRU as a reasonable proxy for the Fed's desired rate for unemployment historically. In practice there is a lot of debate about where Nairu really lies.

The Fed's rules suggest a framework in which policy should tighten when the PCE is over 2% (positive on the chart) and when the U-rate is below Nairu (negative on the chart). Policy should ease when PCE is below 2% (negative in the chart) and the U-rate is above Nairu (positive in the chart). I have applied this framework to 204 quarterly observations since 1961-Q1. The formula points to 67 easing quarters and 31 tightening quarters. The remaining 106 quarters are policy conundrums. Thus, past experience suggests that the Fed will more than half the time be in a zone in which its dual mandate (dueling mandates) will be pulling it in opposite directions. How the Fed resolves this conflict will be a key for market participants.


Historic data

The two tables above establish the Fed's options and the frequency with which it has encountered those options since 1961. In the table 'Too high' for the PCE means above 2% while 'too low' is below 2%. 'Too high' for the unemployment rate is above Nairu,' too low' is below Nairu. We use the definition of Nairu offered by the CBO (Congressional Budget Office).
This framework is too taxonomic for policy and it does not deal with the borderline problem (there are no 'horseshoes' or 'hand grenades' here; we assume the policy variables are either too high or too low and never 'just right'). It nonetheless provides a picture of the Fed's dilemma with a reasonable estimate of the frequency with which the Fed will find itself in some sort of policy conflict. This position is what interests us. Since we know what it will do when it is in a no dilemma situation.

Since 1961 the Fed has had clear tightening episodes 32% of the time. It has had clear easing episodes 15% of the time. It has been torn by deflation 41% of the time. It has seen both unemployment and inflation too low 11% of the time. Over 50% of the time the Fed has been faced with a policy dilemma.

The one thing that history makes clear is that when the Fed swerved from its inflation fight to attend to a too-high rate of unemployment, it usually made a mistake. This is not my ideology talking, it is the facts of this exercise and the lesson of history. It is well documented that Arthur F Burns, former Fed Chairman, ran the Fed with multiple monetary aggregates as 'targets' using them to justify the policy that suited his political objective. In 1971 in the early stages of recovery the Fed saw its first serious policy quandary. The second came in 1975 and 1976. In those instances the Fed ignored too-high inflation and eased policy to try to reduce unemployment. The Fed did stop easing policy but did not stop soon enough. Both of these were clear 'mistakes' that emerged as a part of the end game that policy plays as a recession ends. In both cases the Fed did not pay enough attention to inflation, which was too high and as a result inflation accelerated and policy wound up tightening by even more. Economists recognize this as the fallacy of the Phillips curve relationship. There is no long-run trade off between inflation and unemployment. The current dispute over how the Fed should conduct itself with a dual mandate has more to do with political disputes than with economic issues as in the Burns era. The economic issues have been long since settled.

Under Paul Volcker and Alan Greenspan, since late 1979, a policy that was based on the notion that the Federal Reserve helped growth most when it kept inflation low, resulted in some of the best monetary policy making in U.S. history spanning nearly 30 years. The policy ended in a financial crisis that stemmed from poor regulatory oversight, not bad monetary policy. But the ashes of the crisis brought back an explicit dual mandate as Congressional leaders, unwilling/unable to take the hard fiscal steps needed, have instead pushed that job off on the Fed by encouraging a revival of the dual mandate.

The only quandary periods in which the Fed could and did 'cheat' successfully on its inflation mandate to pay some attention to unemployment reduction were the periods in which the quandary was only technical in nature. By that I mean periods in which inflation was barely above 2% and did not eventually accelerate. But such episodes are only really identifiable ex-post. There were several of them after the year 2000.

As the Fed embarks on a policy where it claims to have two separate and equal targets it is stepping into the dangerous-unknown. Under Arthur Burns it served a monetary master but with five separate targets. Now it has two wholly different objectives. Still, the Fed argues that it will not let inflation get out of control. We can only wonder exactly how the Fed is going to walk that bifurcated walk and adhere to that un-walkable line. Making policy based on inflation intolerance has produced the best results in practice: in the U.S., in Germany and in EMU. We know that given the mood in Congress the Fed can't say that it will do that. We know the Fed has identified an inflation level as consistent with its inflation mandate, it has not done the same with the rate of unemployment. All that is suggestive of Fed priorities, knowledge, abilities and limitations. But it is nothing more than being suggestive.

We will only know about the Fed and its actual policy choices when we have had time to observe exactly how it will navigate these treacherous waters. The Fed has purposely left its approach as well as its very goals vague and even contradictory. But then, that is its mandate, isn't it?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.