This guest commentary was written on Thursday by Mike O'Rourke of JonesTrading.
Once in a while you come across a piece of Federal Reserve research that may be pivotal or groundbreaking. We believe the team at the Boston Federal Reserve has come up with such a piece of work.
Boston Fed President Eric Rosengren presented the topic at the Brookings Conference today. The title of the 64 page research paper is “Should the Fed Regularly Evaluate its Monetary Policy Framework?” In short, Rosengren discusses that the Bank of Canada reviews its policy framework every 5 years in order to make sure it is applicable to the structure of the economy. Rosengren advocates that the Federal Reserve should employ a similar self-evaluation process, although over a longer time frame, but one it which an early review can be called.
What makes the paper special is the manner in which the conclusion is drawn. The Boston Fed team briefly highlights the historic policy objective of the various major iterations of the Federal Reserve as policy morphed starting with the 1913 Fed that was created for stabilizing the Banking sector. Most importantly, a number of observations in the paper are applicable to the current state of the economy.
On numerous occasions, we have argued that the problems the US economy has encountered during much of the recovery are structural ones, and that the FOMC was applying pre-2000 thinking to its policy approach. Thus, the indefinite unconventional accommodation was not the proper approach and the less success the Fed had, the more aggressive it became. An analogy for this approach would be using last year's flu vaccine for this year’s flu, even though the strains are likely very different.
The Boston Fed paper talks about the 2012 adoption of the formal inflation target of 2%, and notes that a formal target was not given for the Unemployment Rate. At the time, the Fed’s longer run target for Unemployment was 5.2-6%. As the economy improved, its target moved. Today, the FOMC’s longer run target for Unemployment is 4.5%.
“First, admittedly the choice of the 2 percent inflation target reflected a commonly used target of other central banks, and was consistent with a literature that viewed a 2 percent target as likely to be in the neighborhood of optimal. However, much of that literature was based on pre-crisis research that estimated that the effective lower bound for the policy interest rate would rarely be hit…. Moreover, the probability of hitting the effective lower bound is higher in an economy with a low equilibrium real interest rate, as would be associated with our current characteristics of slow productivity growth, slow population growth, and aging demographics. In fact, the optimal rate of inflation may move around just as does the natural rate of unemployment.” The Boston Fed continues, “the U.S., Euro Area, and Japan have all fallen short of their inflation targets, regularly and quite consistently…Notably, undershooting on inflation has occurred despite aggressive use of less-traditional monetary tools.”
To us, it appears there are now some at the Fed recognizing the misdiagnoses of the economy and the incorrect prescription.
The paper also highlights what many on Wall Street will now focus on as an important recession indicator - the 12 month change in the Unemployment Rate. The Boston Fed observes, “from 1949 to the present. The recurrent feature here is that whenever the unemployment rate increases by more than one-half of one percentage point, the economy always falls into a recession.”
But it gets more interesting.
The data “shows a pronounced tendency for the unemployment rate to dip significantly and persistently below these estimates of the natural rate at the end of expansions. In every case, this overshooting is followed by a recession. The depth of the overshoot varies, and the magnitude of the ensuing recession varies, but the pattern is nearly perfect for post-war U.S. economic history.”
The paper proceeds to note, “In other words, the recurrent pattern was one where the tightening of monetary policy was expected to slow the economy down gently from above-capacity to full employment. Ex-post, one might judge that monetary policy contributed to the unexpected recession, but this is not what the Federal Reserve Board staff was envisioning ex-ante.” It is important to remember that the current Unemployment Rate is more than half a percent below the FOMC’s longer run target.
The belief that the Federal Reserve tends to take policy too far in one direction and then the other is not a unique revelation, but to have it hypothesized by a Federal Reserve Bank is. It is best to conclude with the Boston Fed’s perspective, “The empirical record of policymakers’ ability to engineer a growth recession that nicely lands the economy at full employment without morphing into a full blown recession is not comforting. Similarly, a soft landing from an overheated economy – whether unexpected or not – to full employment has been a recurrent feature of past forecasts, but not of actual outcomes.”
Think of all the times Fed officials asserted they would defend the 2% inflation target symmetrically from both above and below. First, that very well may be the wrong level, and second, maybe it was the Unemployment Rate they should have been targeting. The team at the Boston Fed is correct. The policy framework should be evaluated from time to time so that the medicine prescribed is appropriate for the illness and you don’t buy Trillions of Dollars of assets you don’t need.
This is a Hedgeye Guest Contributor research note written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.