Tim Duy has an excellent piece in Bloomberg, discussing the Fed’s perspective on the economy:
Core leadership at the Federal Reserve appears determined to normalize policy via interest rate hikes and balance sheet reduction. But they have run up against a significant roadblock because the inflation data stubbornly refuse to cooperate with their forecast. Don’t expect that to deter leaders of the U.S. central bank just yet. They generally view the inflation weakness as transitory. A labor market circling around full employment serves as the justification they need to keep their foot on the brake.
And if that weren’t enough, they can pivot their focus toward financial stability. Indeed, that’s already underway. But be warned: that road will almost certainly lead to excessive tightening. In it you can see one path by which this expansion comes to an end.
I believe the key test will occur in 2018. If inflation stays low, the Fed will need to change course or else lose credibility. Duy worries that low inflation might not be enough to get the Fed to back off from its policy intentions:
Still, one would reasonably think that low inflation would eventually worry a central bank with an inflation target. Indeed, the minutes of the June FOMC meeting noted that “several” participants were concerned that recent inflation weakness would be more persistent than transitory. If such concerns appear justified as the year continues, and especially if combined with a softer labor market, the Fed will reduce its projected path of interest rates.
But the Fed has another worry — that of financial instability driven by a persistent low interest rate environment. That worry was on clear display in recent weeks. Yellen described asset prices as “somewhat rich.” Vice-Chair Stanley Fischer worried that low interest rates are driving home prices higher. And New York Federal Reserve President Bill Dudley warned that the Fed needs to account for the “evolution of financial conditions” when setting policy.
I think Duy is right to be somewhat concerned. It seems to me that the Fed is wrong about both inflation and asset bubbles, for essentially the same reason. In recent decades, the Fed has pretty consistently overestimated the natural rate of interest. If the natural rate is lower than the Fed assumes, then both of these claims are true:
1. Equilibrium asset prices are higher than the Fed believes.
2. The Fed’s current policy stance is tighter than the Fed assumes, and hence unlikely to deliver on target inflation going forward.
The markets have been telling us that:
1. The Fed is likely to raise rates by less than it assumes.
2. Inflation is likely to be lower than the Fed assumes.
3. Assets are worth more than the Fed assumes.
Three areas of disagreement, but all boil down to the issue of the equilibrium or “natural” rate of interest.
It’s quite possible that the Fed will be right and the markets will be wrong. That’s happened before. But if I were a betting man I’d put my money on the markets.