So about 12 hours ago, we posted some Monday night reading that took a closer look at the “soft” versus “hard” data debate.
One of the questions that piece explored was the extent to which consistently disappointing “hard” data and softening “soft” data could affect the Fed’s reaction function.
I mean look, as with a lot of other things, we’d all like to see this economy get a little bit “harder.” Yes, the “soft” data has been nothing short of euphoric up until a few weeks ago, but on a whole lot of levels, the words “euphoria” and “soft” don’t belong in the same sentence.
In the same “vein,” Goldman is out Tuesday morning looking at another economic juxtaposition: tentative realized inflation versus an overheating labor market.
Ultimately, the bank says that if history is any guide, the committee would prefer to launch a series of “preemptive” tightening strikes to rein in the labor market even if “realized” inflation is still looking sketchy.
This may sound like an exceedingly boring subject … wait… let me rephrase… this is an exceedingly boring subject, but if you want to keep your finger on the pulse of the FOMC, you should read the following.
The decline in core PCE in March to a year-on-year rate of 1.56% adds weight to a familiar dilemma for the FOMC: the two sides of its mandate are sending different signals about the urgency of further tightening. While the labor market says get on with it, the inflation picture asks, what’s the rush?
In our view, the US economy has now reached full employment and is likely to overshoot meaningfully, a path that has often proven risky. From this perspective, the case for further tightening is strong. But over the last few years, dovish critics have argued that ensuring a return to the 2% target should instead take precedence, and the inflation outlook is highly uncertain. Such doubts about inflation returning to target likely play a role in the market’s still skeptical expectations about further hikes in coming years.
We expect this dilemma to largely resolve itself in coming years as inflation accelerates to and beyond 2%. But what if progress on core PCE is more limited despite labor market overheating, and the Fed’s dual mandate dilemma persists? In today’s note, we argue that both recent debates and the 1999-2000 hiking cycle suggest that even in that case market pricing would likely prove too complacent.
We begin by briefly recapping how the Fed has handled this dilemma in the current cycle. As Exhibit 1 shows, the decisions to taper QE and to lift off from the effective lower bound in December 2013 and 2015 came after years of below-target inflation with real-time core PCE still at just 1.1% and 1.3%, respectively. While core PCE exceeded 1.7% at the time of the last two hikes, some participants had hesitations then too.
The strongest case for waiting for an inflation pick-up came from President Evans and Governors Brainard and Tarullo, who cautioned against hiking “preemptively” in 2016. Ultimately, however, the leadership put greater weight on the concern that labor market overheating would force abrupt tightening later. A second iteration of the debate appeared to arise in late 2016 with discussion of the merits of running a “high-pressure economy,” but again the Committee judged it more prudent to avoid the risk of overheating. In short, the debate over how to respond to a combination of subdued inflation and the threat of labor market overheating is by now familiar to the FOMC, and it appears largely settled.
We next look at how the Fed dealt with a similar situation during the 1999-2000 hiking cycle. At the time of the first hike in June 1999, the unemployment rate was 1pp below the Fed estimate of its structural rate, but inflation was “remarkably subdued,” with core PCE around 1.3%. Many participants viewed this situation as unsustainable. Chairman Greenspan warned, “Where we do have a problem is in the labor markets … we have a situation that is out of equilibrium. We don’t see it in the price data currently. What we do see is a situation that, if it continues indefinitely, must create some problems in the labor market and eventually in unit labor costs and prices.” While not everyone agreed, the FOMC ultimately decided that a hike was a “desirable and cautious preemptive step” to reduce the “significant risk of rising inflation.”
The FOMC continued hiking through May 2000 by a total of 175bp. As Exhibit 2 shows, throughout this period the unemployment rate fell further, but core inflation picked up only moderately. Despite the subdued inflation data, the FOMC worried that “the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future,” and it acted to preempt them. It stopped only once demand had decelerated to a pace that no longer threatened further overheating.
The major lesson of this period is that concern about labor market overheating and future inflation can drive steady, substantial tightening even absent a problem with realized inflation. We see three other lessons too. First, wage growth often substituted for evidence of price inflation in FOMC discussions. Second, while the staff lowered its structural rate estimate, it did so too slowly to close the gap with the actual unemployment rate, so that overheating was not revised away. Third, the staff’s estimate of the distant terminal rate—something like a neutral real rate estimate—rose significantly over this period, nearly keeping pace with the actual funds rate.
The FOMC ultimately hiked somewhat more quickly than the staff projected at the outset, as shown on the left hand side of Exhibit 3. We see an important parallel here: as the FOMC continued tightening then until demand slowed to a sustainable pace, so concern about labor market overheating today is likely to drive steady tightening until payroll growth slows to a sustainable pace, and there is still a long way to go. A large downside miss on inflation relative to our expectations could of course change this picture. But the FOMC appears reasonably comfortable hiking “preemptively,” and we think that if progress toward the target is only moderate, market pricing would still likely prove too complacent.