In the fall of 2015, Federal Reserve Governor Lael Brainard began building the intellectual framework to slow the pace of rate increases. Not soon enough to stop the rate hike of December that year, but the rest of the Fed soon fell in line, and the projected four rate hikes in 2016 became only one actual hike - a hike delayed until December 2016.
Can she shift the focus of the FOMC again? She made a valiant effort today. But will her colleagues get on board as they did last time? A key issue: she doesn't have the downtrend in the economy and financial markets of 2016 to back her up.
Brainard begins by acknowledging the problem facing the Federal Reserve:
The labor market continues to bring more Americans off the sidelines and into productive employment, which is a very welcome development. Nonetheless, there is a notable disconnect between signs that the economy is in the neighborhood of full employment and a string of lower-than-projected inflation readings, especially since inflation has come in stubbornly below target for five years.
The US economy is in the midst of what could easily become a record-breaking expansion. Labor markets have shown dramatic improvement in that time as steady job growth pushed the economy into the range of full employment. Moreover, the outlook remains bright:
There has been a noteworthy pickup in business investment this year compared with last year. Investment in the equipment and intellectual property category has risen at an annual rate of 6 percent so far this year after remaining roughly flat last year. The latest data on orders and shipments of capital equipment suggest that solid growth will likely continue in the second half of the year. In addition, oil drilling had rebounded this year after dropping sharply last year, although Hurricane Harvey creates uncertainty about drilling in coming months. While lackluster consumer spending was one of the key reasons for the weak increase in first-quarter gross domestic product (GDP), growth in personal consumption expenditures (PCE) bounced back strongly in the second quarter, and recent readings on retail sales suggest another solid increase in consumer spending this quarter.
And, as Brainard notes, even if the anticipated fiscal stimulus has failed to materialize, the economy has been supported by a global upturn in growth as well. Sure, Hurricane Harvey may dent the short-term numbers, but the medium-term picture is solid.
But all is not well:
In contrast, what is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization.
Brainard runs through the usual suspects offered as explanations for the inflation numbers - import prices, resource utilization, and transitory factors - and finds them all wanting. So what's going on? She turns her attention to a fundamental element of the Fed's inflation model:
... In many of the models economists use to analyze inflation, a key feature is "underlying," or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of as the slow-moving trend that exerts a strong pull on wage and price setting and is often viewed as related to some notion of longer-run inflation expectations.
There is no single highly reliable measure of that underlying trend or the closely associated notion of longer-run inflation expectations. Nonetheless, a variety of measures suggest underlying trend inflation may currently be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective...
This is a big deal. Brainard suggests that inflation expectations are not anchored at 2 percent. And they have not become unanchored to the upside, as so many of her colleagues fear will happen if they do not act preemptively. Expectations are unanchored to the downside.
Why are expectations falling? Brainard posits that perhaps households and firms are reacting to the persistent undershooting in recent years. She also relates this to low neutral interest rates, noting that the resulting lack of conventional monetary policy power increases the episodes of below-target inflation, further entrenching low inflation expectations.
Now comes the tricky part. How should policymakers respond? Can low unemployment do the job? This is interesting:
Given the flatness of the Phillips curve, it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective if we were to rely on resource utilization alone.
For all these reasons, achieving our inflation target on a sustainable basis is likely to require a firming in longer-run inflation expectations - that is, the underlying trend. The key question in my mind is how to achieve an improvement in longer-run inflation expectations to a level that will allow us to achieve our inflation objective. The persistent failure to meet our inflation objective should push us to think broadly about diagnoses and solutions.
It is not enough to just force down unemployment. Policymakers need to match such a policy with a commitment mechanism that pulls up inflation expectations. And that mechanism likely includes explicit overshooting of the inflation target.
She highlights this point in the context of setting rates. Brainard believes the neutral rate is low and likely to stay low (this will be exacerbated by the balance sheet run-off). Consequently, the Fed might reach the neutral level of the Federal funds rate in very short order. That means it needs to be cautious moving forward, and should adjust down the expected path of tightening accordingly. Moreover, central bankers need to match the policy with a stronger goal:
To the extent that the neutral rate remains low relative to its historical value, there is a high premium on guiding inflation back up to target so as to retain space to buffer adverse shocks with conventional policy. In this regard, I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time
But will Brainard's colleagues listen as they did in 2016? At that point, the economic conditions appeared fragile as the impact of the oil price crash filtered through the manufacturing sector. Moreover, financial conditions had tightened with a period of higher corporate yield spreads, declining equity prices, and a strong dollar. The opposite is true now - not only does the economy look healthier, but financial conditions have loosened despite Fed tightening. So, I am not yet convinced she can carry the day. But this is undoubtedly a space worth watching.
Bottom Line: Brainard is making a push to slow the pace of rate hikes. I am not sure she will be as successful as her last effort to change the course of policy. But she still has two important takeaways for investors. First, if you think interest rates will rise sharply, think again. The neutral rate of interest is too low to expect much more tightening - we need much faster growth to justify a higher estimate of the neutral rate. Second, assuming she is right and the Fed doesn't take her advice, her colleagues are positioning themselves for a substantial policy error that would both bring the expansion to an end sooner than later and further entrench disinflationary expectations. And that would only make the Fed's job harder in the future.