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The Fed Signals a Tiny Tightening



As was widely expected, the Federal Open Market Committee (FOMC) raised the target for the federal funds rate by 0.25 percentage point to a range of 1¾ to 2 percent at its June meeting. This was the second hike in 2018. The FOMC remains closely divided on whether it is likely to raise rates a total of three or four times this year, and only one participant's changed projection was enough to push the median from three to four hikes. The committee slightly decreased projected rates of unemployment through 2020, increasing the internal inconsistency of its projections already apparent in a forecast that shows an extended period of unemployment below its long-run level yet no significant rise in inflation.

Chair Jerome Powell described the Fed’s policy dilemma as one of not tightening so fast as to push inflation back below the 2 percent target yet not tightening so slowly that inflation dramatically overshoots 2 percent, forcing a more abrupt and damaging tightening later. An inconsistency within the FOMC projections highlights this dilemma: The median FOMC projection for the unemployment rate keeps it a full percentage point below its long-run level in 2019 and 2020, yet the median projection for core inflation shows virtually no increase in these years relative to 2018. These projections run counter to the standard Phillips curve model of inflation that says inflation should increase as long as unemployment is below its long-run, or natural, rate. There would be no inconsistency if FOMC participants no longer believed in the Phillips curve, yet Powell used the Phillips curve framework repeatedly in responding to questions.

Powell raised the possibility that the natural rate of unemployment may be significantly lower than currently estimated, which would be consistent with the inflation projections. He noted that the FOMC’s estimate of the natural rate has fallen roughly a percentage point since 2012. My own view is that the FOMC was wrong to raise its estimate of the natural rate of unemployment—which was 4¾ percent in 2007—to 5½ percent in 2012, and that the current estimate of 4½ percent is about right. There has been a gradual decline in the natural rate over the past 30 years as the labor force has aged. But a sharp further drop to 3½ percent seems unlikely.

The more likely resolution of the inconsistent projections is that inflation will rise more than the FOMC projects in 2019 and 2020. Powell said that the Fed’s internal models generally do not show much rise in inflation. There is probably a range of internal models, some of which show significant inflation overshoots and others not. Models that put a high weight on the past 10 years of stable inflation and do not allow for the asymmetric effect of downward wage and price rigidity are likely to project only a small rise in inflation going forward. However, even a very flat Phillips curve would call for inflation to rise above 2.1 percent by 2020, if unemployment follows the path projected by the FOMC.

A minor note is that the Fed narrowed the band between the interest rate it pays on excess bank reserves and the interest rate it pays on overnight repurchase agreements from 0.25 to 0.20 percentage point. This was a relatively minor technical adjustment in response to the tendency for the federal funds rate to trade near the top of its range in recent months.

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