The State of the Union, Fed Edition

I didn’t watch the State of the Union address last night. But I did read two different analyses of what was said and what the mood in the chamber was. The overviews were consistent with a recent Gallup poll that showed division and heavy partisanship on this issue.

Two things: I think the state of the nation is as good as it is going to get during this business cycle — at least from an economic perspective. And since this is an econ site, when it comes to state of the union addresses, I am actually a lot more interested in what Janet Yellen has to say in her last FOMC statement today.

The Fed chair has consistently shown support for the Phillips Curve as a driving force for how the Fed should employ monetary policy. Her view is that there is a trade-off between employment and inflation when the headline unemployment rate is as low as it is today. And as a result, as the unemployment rate has dropped, she has advocated a measured but pre-emptive tightening to forestall unwanted inflation, even though the rate has been below the Fed’s target for over five years now.

Janet Yellen is a consensus-builder. So her views likely reflect a wider belief in Phillips Curve thinking among voting members of the Federal Open Market Committee. The most important question which Chair Yellen could answer is, “how many rate increases does the Fed believe are warranted if inflation remains below target?” A second corollary is this one: “If inflation does rise toward two percent, would your answer to the first question change?”

The Fed’s stated belief is that the US economy will grow 2.5% in 2018 and the unemployment rate will drop to 3.9%, while inflation will rise to 1.9%. If that is the baseline, then it is the outcome that supports the Fed’s stated projection of three rate increases for 2018. We should assume that any deviations from this outlook could change the Fed’s policy stance.

Let’s take the first question on inflation undershooting the 1.9% projection. Right now, the inflation rate in the US is 1.7%, using the Fed’s preferred measure.

If you strip out the volatile food and energy components to see the trend, that number falls to 1.5%.

But in both cases, the numbers are rising toward target. So Janet Yellen could reasonably say to us that the Fed’s projections are on target, setting us up for a first rate increase in March and a second by June.

But what if, those measures fall, while the unemployment rate and the growth rate remain largely on track? Does the Fed dial back its projections for three rate hikes, and if so, how much does the inflation rate have to fall to change the Fed’s response?

Janet Yellen won’t be able to answer these questions because she is about to retire. But it’s the second question that gets interesting though because the Fed has always said monetary policy is symmetric, meaning that deviations from the target 2% rate are treated equally whether above or below target. Of course, I don’t believe that.

How is the Fed supposed to maintain a three-rate increase stance in an economy that it says is at full employment and with asset markets booming if inflation is above its target? I don’t see it, purely from a ‘political’ perspective. The Fed is supposed to take the punch bowl away when the party is out of control. It would lose credibility for having the will to do so, if had a symmetric policy response, with headline unemployment levels this low.

The conclusion here has to be that the Fed is boxed in. Falling inflation numbers will give it some measure of policy wiggle room. But if growth, employment or inflation surprise to the upside, we should expect the Fed to become more aggressive in raising the Fed Funds rate.

This is not fully priced in.

Source: CME Group

Right now, we see three rate hikes by the end of the year as about 64% priced in, with one rate hike 78% priced in for the March meeting and two 61% priced in by June. If the data on inflation move up, these numbers will move up as well.