Fed Economists Deliver Ammo for Hawkish Approach to Inflation

“Because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.”

Let’s break the above quote apart and put it in perspective:

  • Waiting with rate hikes until inflation materializes is undesirable.
  • This is particularly true today after years of global QE and zero-interest-rate policy, when “outsized deviations of inflation” – such as a sudden and hard-to-control surge – “are a plausible outcome.”

The quote is the conclusion of the 39-page research paper by five economists at the Board of Governors of the Federal Reserve, of which Jerome Powell is chairman. The researchers used stochastic simulations to outline how two uncertainties – inflation dynamics and something the Fed calls the natural rate of unemployment (we’ll get to them in a moment) – “affect the choice of strategies for monetary policy.”

The paper was released with careful timing ahead of Powell’s speech at the Jackson Hole symposium, where he defended the Fed’s “gradual” approach to rate hikes against attacks from both sides – those saying they weren’t fast enough, given what’s happening on the inflation front, and those saying that the only good money is cheap money.

The paper wasn’t so balanced. It gave fuel to the discussion at the Fed on how fast to raise rates now that inflation has hit the Fed’s target of 2%, based on the Fed’s preferred measure, core PCE, which has been hovering between 1.9% and 2.0% since May.

The crux is the relationship between the unemployment rate (3.9% in July), a level traditionally associated with effects where labor market tightness leads to rising wages which then pushes up prices. This is the classic model, embodied by the Phillips curve.

Diminishing “labor market slack” is held responsible for wage increases, and therefore higher demand, which leads to higher inflation.

In terms of this slack, the research by the Fed economists focuses on the “natural rate of unemployment” (u*). For monetary policy setters, this is a key variable. If unemployment falls below this rate, whatever this rate may be, the economy begins to build up inflation pressures.

The Congressional Budget Office releases its own estimates of a similar concept, the Non-Accelerating Inflation Rate of Unemployment, or NAIRU, which currently is pegged at 4.55%.

Neither NAIRU nor the “natural rate of unemployment” (u*) can be measured but must be inferred from other information. As central as this rate is to the entire rate-hike debate, it’s too squishy to be nailed down, and it’s mobile – it has dropped substantially since the Great Recession.

“We’re learning about the real location of the natural rate of unemployment as we go,” explained Powell in response to a question at the press conference after the June 13 meeting. “It has moved down by more than a full percentage point since 2012. So it’s not so simple as thinking we’ve just got to go ahead and get the rate up.”

Where is this rate today? There’s “a range of views,” Powell said. “Some people [on the FOMC] are in the low 4’s.”  But…

“We can’t be too attached to these unobservable variables. I think we have to be practical about the way we think about these things and we do that by being grounded in the data and what we see happening in the real economy.”

OK, I got that. The Fed doesn’t have a good handle on where this natural rate of unemployment is, but it must make interest rate decisions based on it.

The principle is this: Once unemployment (currently 3.9%) falls below u* (Fed estimates for u* range from the “low 4s” to around 4.7%), inflation starts to take off, and the Fed has to raise rates to nudge up the unemployment rate to say 4.5% or 5% in order to nudge down inflation.

But there are lags at every stage along the way:

  • Between rate hikes and when unemployment begins rising
  • Between rising unemployment and when demand begins to back off
  • And between when demand backs off and the moment inflation begins to edge back down.

This lag is key. During that lag, inflation may overshoot because the process takes too long, and then the Fed has to tighten more and faster to grapple with higher inflation, which causes the unemployment rate to jump far higher than originally planned. And voilà, a mess called a recession – or worse.

And so we get the concise answer of their research, stochastic simulations, charts, and tables in the paper’s conclusion:

This paper has shown that because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.

This is a straightforward counterpoint to a few FOMC members (such as St. Louis Fed President James Bullard) who continue to argue that moving more slowly, or not moving at all, on interest rates is preferable at this time because inflation is still not above target – a school of thought that sees it as preferable to let inflation run hot before raising rates, regardless of what comes afterwards.

The paper lays the intellectual foundation – the type economists appreciate – for pushing on with rate hikes until somewhat higher unemployment prevents inflation from taking off, under ideal circumstances.

But more likely, since inflation may already have taken off by then, given the lag, even higher rates would be needed to nudge up unemployment even further to bring inflation back down before it gets out of hand entirely, a risk that the paper outlines, as “outsized deviations of inflation from its target are a plausible outcome,” and which should be avoided by not waiting for above-target inflation to materialize.

My new measurement tool of the Fed’s policy direction spiked 150% from year ago. Read… Introducing My New Fed-Hawkishness-O-Meter

Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.

  49 comments for “Fed Economists Deliver Ammo for Hawkish Approach to Inflation

  1. Some Guy says:

    “This lag is key. During that lag, inflation may overshoot because the process takes too long, and then the Fed has to tighten more and faster to grapple with higher inflation, which causes the unemployment rate to jump far higher than originally planned. ”

    I agree that the lag is key, but doesn’t it seem more plausible that the lag will cause rates to overshoot and cause a recession (i.e. the increase in rates is enough to slow the economy, but they don’t wait to find this out, so keep raising rates past this point until the economy breaks).

    I’ve never seen any other outcome in my lifetime, but maybe this time is different.

    • Wolf Richter says:

      Yes, because of this lag in inflation, it ends up getting worse than expected, and the Fed then pushes rates up higher and unemployment up higher, to contain inflation, and then when it finally is able to contain inflation and bring it back down, unemployment is such that demand drops enough to create a recession. The paper pointed this out, and I also said this in the article. Hence the need to start early and be persistent.

  2. Littlebit says:

    If they would calculate inflation the way we have to it would be a totally different story. My SS check is down 13% due to insurance increases. My “that don’t count” grocery bill is up 23%. My utilities are up. Why don’t they use the real figures and quit lying to us? discounting the two things we absolutely have to have is a bit off the mark.

    • Don’t worry, your utilities will go back down again when oil hits the floor and the next recession breaks and deflation rears its wonderful head!

      • Frederick says:

        Deflation is better than inflation For us little people anyway

      • Petunia says:

        Utilities never go down. Even when special assessments for hurricanes sunset, the companies fight to keep the charges and mostly get to keep them. We have the best govt money can buy.

    • RagnarD says:

      I realized the other day why they don’t include food and energy.

      It’s not because they are too volatile, it’s because you can’t whittle them down to nothing via “hedonic quality adjustments”.

      “The core CPI index excludes goods with high price volatility, such as food and energy. This measure of core inflation systematically excludes food and energy prices because, historically, they have been highly volatile and non-systemic”

      What’s been more volatile over the past 10 years?

      Gasoline/ Electric Bill / Bread/eggs/milk/chicken
      55″ LCD TV/ 1 Terabyte Hard drive / LED light bulbs?

      • Argus says:

        Volatility is just a weak excuse. Food and energy are the two things the poor need most. They are excluded (here in Canada as well) so that the government does not need to increase pension payments to accommodate inflation.
        Over the past year, a brick of cheese in a local supermarket has gone from 12 to 14 dollars for the same quantity, chicken is way more expensive, shrinkflation can be seen in a range of foodstuffs etc.

    • Gershon says:

      Bingo. The Fed’s $15 trillion dollars in funny money “stimulus” mainlined straight to its favored Wall Street investment banks enriched a corrupt .1% in the financial sector and enabled them to buy up the distressed assets of the proles on the cheap, while debasing every hard-earned dollar in your wallet and mine. Now the Fed uses our fake CPI numbers to obfuscate the true rate of inflation so it can keep interest rates artificially suppressed and our Ponzi markets and asset bubbles levitated, while denying SS recipients cost-of-living increases commensurate with actual inflation.

  3. Kenny Logouts says:

    The law of unintended consequences means they won’t balance things no matter how hard they try.

    If they even know the real values any more to use as a guide I’d be surprised.
    Perhaps the Fed has secret/very obscure trackers that are accurate?

    Undershoot, overshoot, whatever, it all feels like rearranging the deck chairs on the sinking Titanic to me.

  4. J.M.Keynes says:

    – Well, that seems to be the interpretation of WOLFSTREET. Because according to another source on the internet, the FED wasn’t in a hurry to raise rates.

    • Wolf Richter says:

      “Gradual” is still the operating principle. No one said “in a hurry.” “Gradual” likely means 4 hikes this year. But “gradual” might also mean a slightly faster pace next year.

      BTW, these are 5 Fed economists that did the research and wrote the paper, not me. The paper is linked. So read it. It’s got a lot of interesting charts too. But it’s a little hard to digest.

  5. Mark says:

    Since these people, the lovely Fed, have their jack-boot on the throats of the “little people” (unrich) Americans –

    When is the next Fed election of these people scheduled ?

    Certainly our free country has elections to cover this . Right ?

    • Frederick says:

      End the FED asap Audit Fort Knox gold reserves

    • Wolf Richter says:

      The 7 members of the Board of Governors are appointed by the President and confirmed by the Senate. Powell is Trump’s guy. So that’s in our democratic tradition (like the Secretary of the Treasury is appointed by the President). These members form the core of the FOMC and have a permanent vote.

      The rest of the members of the FOMC are the governors of the 12 regional Federal Reserve Banks, which are privately owned. These folks are put in their jobs by the boards of those FRBs, and you’re correct, democracy has nothing to do with this. But only the governor of the NY Fed has a permanent vote on the FOMC. The others rotate into and out of voting slots.

      • Frederick says:

        And they are all illegal and criminals Fixed it for you Wolf We aren’t blind and weren’t born yesterday

        • Wolf Richter says:

          Neither you nor I get to decide what’s “illegal” and “criminal.” Lawmakers decide that, and they have spoken on this issue :-]

        • LessonIsNeverTry says:

          Strong words.

          All humans tend to shape environments to benefit themselves. It is natural that the more power a person has, the more that shaping will look evil or illegal to those without power. But, chances are, they are decent people with good intentions. Just like the rest of us. It is just that their shaping has bigger impacts than ours.

          There are exceptions. We have names for them. They are (perhaps) disproportionately represented at higher levels of power, especially in gov’t. Still, I hate seeing ad hominem comments accusing people of criminality.

        • LessonIsNeverTry says:

          Hard to tell with this layout, but my comment was replying to Frederick.

      • Sadie says:

        Good review Wolf.

      • Gershon says:

        With so many “former” Goldman Sachs officials infesting the Fed, and the Fed’s monetary policies benefiting only their “former” employer and its ilk, the idea of the Fed being somehow responsive or accountable to We the People is a bad joke.

    • Gershon says:

      Go to YouTube and watch George Carlin’s “It’s a Big Club and you ain’t in it.” Then you’ll understand what a charade our elections have become, since both parties are bought and paid for by the same oligarch donors. We don’t have “representatives” – we only have owners.

  6. timbers says:

    Mr. Fed, let me fix that or yah:

    “Because monetary policy acts to shift reported inflation away from items contained in the basket of goods and services purchased by most people used to report inflation, waiting for inflation to materialize in official figures before reacting is undesirable, particularly when economic conditions are such that outsized transfer purchasing power (bank bailouts for the Ultra Rich, tax cuts tor Ultra Rich, QE for the Ultra Rich) that could drive reported inflation has been diverted to the Ultra Rich at the expense of those who purchase items used to report inflation, higher than official figures used to report inflation from its target are a plausible outcome.”

    • Bobber says:

      Excellent. I have another one.

      “The Fed must operate within its mandate, which requires balancing employment levels and price control. The mandate also requires that we balance these variables in both short-term and long-term. Interest rates have been suppressed in recent periods, which elevate debt levels, encourage rising government deficits, lower productivity, and elevate asset valuations to historical records. These factors in tur create immense wealth concentration in our society, which is showing clear signs of discord. The long-term health of the economy requires that we continue on out interest rate path. Currently, there is a significant risk that growth of government debt will continue to accelerate, as a percentage of GDP. Therefore, we must also consider accelerating the pace of interest rate hikes”.

      • nick kelly says:

        I believe preserving the purchasing power of the dollar is also part of the Fed’s mandate.

        • Gershon says:

          The Fed’s sole mandate is facilitating the transfer of the wealth and property of the 99% to its oligarch accomplices. It does this through engineered boom/bust cycles every 8-10 years, with the scale of the rapaciousness escalating dramatically since 2008.

  7. L Lavery says:

    If central banks/governments did not have a monopoly on issuing money but private firms[1] also issued their own, I wonder if they’d all have the same inflations rate? If so, would it be 0%?

    [1] Private firms might be in the sole business of issuing money or might issue it as well as run a normal business.

    • 91B20 1stCav (AUS) says:

      A vague memory I have from U.S. history is that many banks in the 1800’s DID issue their own money, with a great deal of malfeasance before this practice was ended. Don’t have a reference handy, but perhaps a more financial history-savvy commenter can confirm and expand on this.

      Another outstanding article, Wolf. Thanks, as always.

      • L Lavery says:

        “…many banks in the 1800’s DID issue their own money, with a great deal of malfeasance…”

        Yes, it’s good that that doesn’t happen with banks nowadays.

    • lenert says:

      Mining company scrip was often only accepted at the company store. If you drove out town to another mining company store, your scrip might not be accepted or discounted. West Virginia’s booming high-tech economy and world class education and healthcare systems are testament to the benefits of private currency.

  8. Paulo says:

    No secrets here. The Fed manipulated policy to save and increase the wealth of the connected, and now tweaks rate timing to ensure wages for working foks won’t rise, thus ensuring this relative and growing inequality continues.

    This is nothing more than Policy for ‘Trickle Down’ economics. Aren’t those crumbs tasty?

  9. Winston says:

    “because inflation is still not above target”

    Not only is there a lag they cannot know accurately in advance, they don’t even properly MEASURE “inflation.” Read the report from the Boskin Commission which managed to find a way to lower the CPI because COLA for entitlement programs were going to grow too large. That was the main problem they identified in the introductory section of their report and they managed to “fix” it by finding a way to lower the CPI via ridiculous substitutions and hedonics.

    Mark Baum: It’s time to call bulls**t.
    Vinnie Daniel: Bulls**t on what?
    Mark Baum: Every-f***ing-thing.
    – film “The Big Short”

    • RagnarD says:

      Exactly. Total head fake. Fed talks about desperately wanting inflation while at the same time doing everything they can to either manipulate it away in the statistics or better yet, simply ignoring the elephants in the room: Stocks, Bonds, Real Estate at all time highs.

      “Thanks for looking into this inflation business, Mr. Magoo.”

  10. Petedivine says:

    It will be interesting to see how increasing global, corporate, government, and public debt interest payments will impact inflation. What I find disingenuous is that the Fed can print Dollars at will, foist their paper upon the economy, and then demand higher interest payments. As people, government entities, and corporations fall into bankruptcy, agents of the bank foreclose on real assets. How much of our taxation is really a pass through to the banking system? Why do I find myself so angry thinking about the Fed and the system imposed upon society. How long before the banking system once again harvests society of its producing assets?

  11. Dale says:

    Another consideration is the Fed’s legal mandate. Per the Humphrey-Hawkins Act, the Fed is actually required to target “zero percentum” inflation. Their present self-imposed “mandate” of 2% is entirely crafted from a desire to run the economy a little hotter than the law allows (and maybe they believe it is easier to recover from too much inflation than too much deflation).

    So while the FOMC has grown accustomed to ignoring their legal responsibilities, maybe Powell is looking forward to a time when he might have to testify in court or in Congress as to why the Fed disobeyed the law for 30 years.

  12. Petunia says:

    Re: the unemployment rate.

    There are many problems with structural unemployment in the country the fed is not addressing. It used to be that the structural component was 1-2%, now it is obviously more. No average wage worker would move to California for a job because they could never live on an average wage there. In fact, we turned down an opportunity to do just that, for that reason.

    The traditional centers of employment have shifted and except for the national capitol and financial services, I couldn’t easily identify them. I don’t think the fed is addressing the structural deficiencies in both jobs and workers.

    When you make $150K in Silicon Valley and live in your car, that is the ultimate symbol of a broken system.

    • Frederick says:

      I agree The system is broken Badly broken indeed and nobody seems to care frankly

      • California Bob says:

        The system isn’t ‘broken;’ it’s benefiting the people* it’s meant to benefit.

        * Hint: It ain’t us.

        • alex in san jose AKA digital Detroit says:

          At $150k, no one’s living in their car here if they don’t want to.

          Even at $35k, if you’re single you can live fine.

          When you add in a wife, the 2.4 kids, a dog and a cat, a white picket fence, and a house painted salmon pink inside a’la The Simpsons, then it gets expensive and yeah you’d be in trouble even at $150k.

  13. Axiom says:

    “If unemployment falls below this rate, whatever this rate may be, the economy begins to build up inflation pressures.”

    The only real example of the kind of inflation the Fed is presumably looking for (labor demands of the 1970’s causing the rise in price of consumer staples), happened in a world where there was relatively liitle global competition, while today there are billions eagerly waiting for the chance at an American job.

    No Indian call centers in the 1970s, no Chinese factories building to the sky. Sorry, any slack in demand can be covered by China. Look at year over year US wages as proof.

    I recall that Paul Volcker raised interest rates rapidlily in a bid to protect the dollar. Well, flash forward and the dollar is so strong it is crushing the emerging markers.

    No, what you’re hearing from the Fed economists is a smoke-screen. The only thing they care about is protecting the dollar (regardless of deficits.)

    The Fed will raise rates rapidly to protect the dollar when both the European central bank and Japan start to seriously raise rates (thus sucking capital away from the USA). Still no competition from that quarter.

    We’ll probably continue on the path of tiny interest rate increases, but only so they can cut at the first sign of trouble. Of course if Trump places 75% tarrifs on all Chinese goods, then we’re in real trouble.

    Since the Fed is unconcerned about asset price inflation, that cannot form the basis for any interest rate increases. They might be more concerned that the indebted US consumer can’t make their monthly credit card payment if rates go too high. That indebted, stressed out individual is the basis for 70% of US economic growth.

    • RagnarD says:

      Excellent point about the broken / non existent employment / inflation connection.

  14. J.M.Keynes says:

    – I have another question: who in the US borrows money with a rate tied to either the FED’s fund rate and/or short term rates (< 1 year)? Companies ? Commercial real estate ?

    – It's certainly NOT the average homeowner because the rate of a mortgage is tied to 30 year yield.
    – But e.g. (some) mortgages in the UK and in Hong Kong are tied to short term rates. And the Central Bank in Honk Kong follows the FED. So, I would assume that home owners in Hong Kong should feel the pinch right now.

  15. GSH says:

    Controlling industrial processes with dead time is a commonly solved problem. The best algorithms are simple PI controllers (proportional integral). The Fed is using a model based algorithm which are more susceptible to oscillation. That is why we get booms and busts/recessions.

    • LessonIsNeverTry says:

      Interesting. I’ll need to read on this. However, isn’t the main issue the fact that the interlocked world economies have no downtime? And trillions of entity to entity relationships?

    • KPL says:

      “That is why we get booms and busts/recessions.”

      Lay it on the door of Greenspan (and then his acolytes, Bernanke and Yellen) and the Fed’s manipulation of interest rates if market falls. The Fed catches a cold the moment the market sneezes. Lower interest rates and nail it to the floor for a long time was the medicine that was administered for the 2000 bust. Since that was not enough in 2008, they added QE (if 1 is not enough keep adding as much as they felt is warranted since the levers to the printing press is with them) and Acroymn money (supplemented by TARP and gun to the FASB’s head) in the guise of saving the system. After 8 years they started raising interest rates “gradually”.

      Since the markets are still rollicking the Fed is still increasing rates “gradually” and doing QT too. It is when the market sneezes the show begins. Let us see how it goes.

      My guess is having seen how close the financial system came to toppling in 2008, it is highly likely this time around they will not wait for a Lehman to happen before going full throttle with the printing press and more QE, not to mention the sitting ducks who are lined up — savers, prudent people, retirees-waiting to be thrown under the bus. After all, you see, they are doing it all to save the common man (otherwise it would be worse for these people) and they also have the courage to act.

  16. QQQBall says:


    Some commentators such as J Williams at Shadowstats reports that the methodology used to calculate UE has changed and that the current rate using past methodology is much higher. Could this be why the current low UE rate is not resulting in wage-push inflation?

  17. AV8R says:

    I (and our President evidently) don’t understand the reasoning behind charging ourselves more in interest on our borrowing when the QE unwind has yet to even scratch the surface of the Fed Balance Sheet.

  18. Steppenwolf says:

    Hm, is anybody buying these arguments?

    According to Henry George, first paragraphs of Progress and Poverty: interest is high when wages are high and interest is low when wages are low. So, fighting wages increases with higher rates will not work. May also not be a bad thing.

    According to a certain Martin Armstrong (yes, the fellon), articulate, pretty logical probable conman: the Fed must raise rates (and is in fact already past due) in order to give pension funds a lifeline. The argument goes: pension funds need higher yields to break even (probably true) and can’t just go all in on stocks (1: regulation, charter, other legal requirements compel them to bonds and gov’t bonds at that; 2: equity markets are tiny compared to bond markets) so gov’t bond yields it is, or basta. Us banks had been laundered solvent, supposedly, over the course of QE, mission accomplished, rest of the world (EM) not so much, which will suffer from higher USD interest rates, capital repatriation.. and the fed had, supposedly, been torn between its national mandate and its responsibility in it’s de facto role as the CB of the world reserve currency in which less fortunate nation’s (and businesses) borrow. Borrowing costs everywhere ought to be much higher on a purely market basis, so these steps are inevitable…

    All the while the fed is saying, they shall push up mortgage rates (borrowing costs, but much of borrowing is mortgages) until people starting losing their jobs? How does that rationale fare against the above?

  19. Ambrose Bierce says:

    The outliers on inflation could be as simple as Iran saying it controls the Persian gulf and the US Navy should get out. At the same time you have to assume some asset prices, like homes will lose value. However if the Fed gives up on rate hikes and rates normalize (lower) then oil prices ought to come down, which may be a catalyst for Iran to shut off supply. You never shut off supply when the price is high. Rinse repeat of that 70s show.

Comments are closed.