On July's FOMC Minutes
From not thinking about thinking about it to just thinking about it
Note: any and all opinions are entirely my own and do not necessarily reflect those of the Cleveland Fed, the FOMC, or any other person or entity within the Federal Reserve System. I am speaking exclusively for myself in this post (as well as in all other posts, comments, and other related materials). No content whatsoever should be seen to represent the views of the Federal Reserve System.
As anyone would expect, the Fed’s asset purchases were one of the main focuses of July’s meeting. In this post, I want to explore some of the Fed’s thinking and what it meant in its forward guidance. There has been much talk about whether now is or is not the time to taper, but this post will mainly focus on answering that question in what I believe is the correct way: what did the Fed mean in its forward guidance, and where are we in relation to that?
The focus of most commentary on the Fed’s minutes has been over this except:
“All participants assessed that the economy had made progress toward the Committee’s maximum-employment and price-stability goals since the adoption of the guidance on asset purchases in December. Most participants judged that the Committee’s standard of “substantial further progress” toward the maximum-employment goal had not yet been met. At the same time, most participants remarked that this standard had been achieved with respect to the price-stability goal….
Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s “substantial further progress” criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum-employment goal. Various participants commented that economic and financial conditions would likely warrant a reduction in coming months.
In summary, expect an announcement on tapering at the FOMC’s September meeting.
“Substantial Further Progress”
This phrase is corrupting my brain. At what point does some progress become substantial progress?
The funds rate has it easier—there is an explicit target. December 2020’s FOMC statement indicated only that rates would remain at zero “until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.” The forward guidance here is largely clear, we basically just need certain numbers to match other numbers. We can figure that we’re likely good to go on the second count, but a good ways away on the second.
Quantitative easing has different guidance. The Fed has indicated that they will continue QE “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” This is distinct from the requirements for the fed to raise interest rates; for interest rates, they have indicated the Fed would need to see maximum employment and inflation at 2% with an upward trajectory, but for QE we need progress toward maximum employment and price stability. Where are we in respect to “substantial further progress” toward these goals?
Substantial further progress in employment is easier to interpret. As I wrote above, just pin a number as a target; January 2020’s 80% working age employment to population ratio, for example. In December this number read 76.3%, and it currently sits at 77.8%. I don’t believe a majority on the FOMC see a 150 basis point increase as substantial further progress, but it certainly is some further progress. But by mid-fall, we will likely be in a situation where the progress is undoubtedly “substantial”, though not completed. But that’s not the qualification for ending quantitative easing anyway.
But one must think hard about progress toward price stability. 2% inflation on average and exceeding 2% moderately for some time, half of the qualifications for raising the funds rate, is not the Fed’s price stability goal. That is the goal of keeping inflation expectations anchored around 2% and nudging them up slightly before raising interest rates.
Price stability is where we drop out the whole “moderately overshoot” thing, and focus on the average. We would want to see the price level start to look like a straight line again—the whole transitory thing will need to mostly pass. The difference between price stability and the overshoot goal is why the Fed is moving toward tapering without rushing toward raising rates. Running through a few scenarios can demonstrate the difference.
Say we are 80% of the way back to January’s employment to population ratio, but inflation is running at 2%, sometimes above and sometimes below. In this situation, the Fed cannot raise interest rates yet, but it can wind down quantitative easing so long as inflation has averaged 2%. If we are 80% there on employment and inflation is running above 5% but averages below 2%, the Fed cannot yet cease quantitative easing. Theoretically, the policy response would be the same if the average were above 3%, too.
Right now we are in the second scenario, where inflation averages below 2% by just about any measurement of the average, but the inflation number itself is decently above the 2% target—this is not price stability! This is shown below.
The Fed cares about core PCE inflation the most. As of right now, however, only if one runs a moving average with a fixed start date of the framework revision in August 2020 is core PCE inflation averaging above 2%. The average inflation rate over the last year is 1.9%, 1.8% over the last three years, and 1.7% since the 2% inflation target was announced in January 2012. Right now, the 2% average has probably not been hit, but undoubtedly will be in the next several months given elevated core PCE inflation. Actual tapering will likely not occur any earlier than November anyway, so there is time.
This is why the Fed will begin to move toward tapering in September. We will, God willing, have made “substantial further progress” toward maximum employment, no matter what meaning one assigns to that phrase. Inflation, by any reasonable measure, will also be averaging 2%. Check and check for the two quantitative easing requirements. For interest rates though, while inflation is above 2% and expectations have shifted up, this is largely transitory and we need to reach maximum employment in order to have two checks. We have at least another year to go before we can have that conversation.
If Not Now, When?
The curse of forward guidance is that you have to mean it, and you have to stick by it. Credibility goes a long way in central banking. In my view, given what the Fed meant when it issued the forward guidance on asset purchases in December of last year, the time to taper is soon approaching. But is it truly time?
While a majority of the FOMC likely believes the necessary conditions to have been met, not all of the FOMC agrees with them:
Several others indicated, however, that a reduction in the pace of asset purchases was more likely to become appropriate early next year because they saw prevailing conditions in the labor market as not being close to meeting the Committee’s “substantial further progress” standard or because of uncertainty about the degree of progress toward the price-stability goal.
The division is over what “substantial further progress” means and is targeted toward. I would love for the Fed to be shooting for at least the record-high 81.9% working age employment rate hit in April 2000, but I don’t think this is what a majority of the FOMC have in mind as the target. Similarly, I can have some sympathy for a higher inflation target, as some have recently argued for. If we’re going to adjust the price stability component of the dual mandate though, we should be going for a nominal GDP target or gross labor income target instead of shifting to a higher inflation rate.
The progress on price stability is difficult to deny, but I can believe that we have substantial further progress still left. It just depends on how much and toward what goal. The FOMC thinks in terms of the unemployment rate, which they figure will sit between 3.8% and 4% in the long run. Those who care only for hitting that number, with no regard for employment ratios, will likely favor tapering now. While the employment ratio is a better measure, it’s just not mainstream enough!
Thinking About It
The FOMC is clearly now just thinking about tapering and no longer thinking about thinking about thinking about tapering. The fed funds rate has a ways to go before its time comes, but the FOMC is running out of members who are ready to argue for more substantial further progress before slowing asset purchases.