Dudley Revisits Exit Strategy

Today New York Federal Reserve President William Dudley gave what was both an interesting and depressing speech.  Interesting in that he provides some new thoughts on the exit strategy. Depressing in that he outlines a case for persistently low interest rates. One wonders why, given such an outlook, the Fed is so firmly focused on the exit strategy to begin with, rather than accelerating the pace of the recovery.

Dudley tries to sound an optimistic note regarding the outlook, including dismissing the first quarter GDP report, but his optimism is tempered, very tempered:

With the fundamentals of the economy improving and fiscal drag abating, I expect the economy to get back on to a roughly 3 percent growth trajectory over the remainder of this year, with some further strengthening likely in 2015.  But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch.

Three percent growth is not exactly anything to write home about; the only thing exciting about 3 percent is that we just can’t seem to get there. Dudley specifically notes weak capital spending and housing markets as key concerns. He senses that the capital spending issue is transitory, but housing less so:

I think housing has been weaker than anticipated because several significant headwinds persist for this sector.  First, mortgage credit is still not readily available to households with lower credit scores.  Second, some people are coping with higher student loan debt burdens that have delayed their entry into the housing market as first-time homebuyers.  This, in turn, makes it more difficult for existing homeowners to sell and trade-up.  Third, there may be some ongoing difficulties increasing housing supply.  The housing downturn was very deep and protracted.  It takes time to shift resources back into this area.  Also, in some markets house prices still appear to be below the cost of building a new home.  Thus, in those markets, it remains uneconomic to undertake new home construction.  Although I expect that the housing recovery will resume, the pace will likely be slow, especially relative to past economic recoveries.

Notice that he does not mention the mortgage rate increase over the past year, instead focusing on issues largely outside the control of the Federal Reserve. In other words, housing is a problem that they can’t fix and thus will simply contribute to weak growth. Regarding inflation, Dudley is optimistic that the trajectory will prove to be in the right direction, but sees little reason to expect any sharp increases. There is simply too much slack in the labor market, evidenced by low wage growth. Here he paints a bleak picture and lays down some markers:

…the trend of labor compensation is running at only about a 2 percent annualized pace.  This is far below the roughly 3½ percent pace that would be consistent with trend productivity growth of 1 to 1½ percent and the FOMC’s 2 percent inflation objective.

Trend productivity growth of just 1 to 1.5 percent is very, very low and feeds into the Fed’s belief that potential growth is in the 2.2 to 2.3 percent range. Dudley’s expected 3 percent growth thus hardly eats into excess capacity. Still surprises me that the Fed remains focused on policy firming when arguably conditions require a delay in the tapering process.

On that inflation target, Dudley argues against the “2 percent is a ceiling” hypothesis:

…once we reach 2 percent, I would expect that we would spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever be exactly at 2 percent because of the inherent volatility in prices.  If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise.  But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective.  This should not surprise anyone.  This is what our “balanced approach” implies.

The operative word here is “slightly.” What is “slightly” above 2 percent? My guess is that as long as inflation remains below 2.25 percent and employment outcomes remain subpar, the Fed will remain on a low-interest rate path (though not a zero rate path). Above 2.25 would be more disconcerting but, realistically, it is unlikely that the US economy would experience higher inflation in the absence of clear evidence that labor market slack had evaporated. In other words, I suspect that if inflation were above 2.25 percent, the Fed would not need to choose between the elements of the dual mandate; the case for a higher rate trajectory would be clear.

Dudley anticipates that the tapering process will continue, and thus turns his attention to the lift-off from the zero bound. Here he admits the reality of the situation. They really have no idea when the first rate increase will occur:

Turning first to the timing of lift-off, how the outlook evolves matters.  We currently anticipate that a considerable period of time will elapse between the end of asset purchases and lift-off, but precisely how long is difficult to say given the inherent uncertainties surrounding the outlook.

I would congratulate him for avoiding the use of a date, but then he includes a footnote pointing to the March Summary of Economic Projections and the embedded anticipation that rates will rise in the middle of next year. Fed officials simply can’t decide whether those projections are meaningful or not.

As far as the pace of timing, that too is data dependent, although given the current forecasts Dudley anticipates a tame trajectory:

With respect to the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves.  My current thinking is that the pace of tightening will probably be relatively slow.  This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening.

And he too expects rates will be subdued over the longer term, laying out three reasons:

First, economic headwinds seem likely to persist for several more years…Second, slower growth of the labor force due to the aging of the population and moderate productivity growth imply a lower potential real GDP growth rate as compared to the 1990s and 2000s.  Because the level of real equilibrium interest rates appears to be positively related to potential real GDP growth, this slower trend implies lower real equilibrium interest rates even after all the current headwinds fully dissipate…Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate.

When it comes to the Fed’s exit from extraordinary monetary policy, Dudley throws in a new twist.  Conventional wisdom is that the Fed would stop reinvesting the principal payments on assets held by the Fed prior to raising rates. Dudley suggests this might not be a wise decision. First, he argues that this might send the wrong signal to financial markets:

Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the Committee’s intention.

Second – which seems to be in contradiction to the first – it that he prefers lifting rates to enhance policy flexibility:

Second, when conditions permit, it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility.  This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa.  Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates.  In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.

Dudley is saying that the Fed can reduce accommodation via raising rates or reducing the balance sheet, and  they should should begin with the former to normalize policy. This reveals his confidence in being able to manage the balance sheet while raising rates, the topic of which takes up the remainder of his speech.  Note the qualifier “when conditions permit.” This is not about tightening policy simply in order to get rates higher; it is about how to tighten policy – what mix of tools to use – when the time to tighten comes.

I don’t quite see the communications challenges Dudley describes. In order to prevent expectations of an earlier rate hike we should hike rates rather than end reinvestments? Not sure this makes much sense. Maybe better to just say that they will reduce accommodation further when appropriate, and that process will involve some mix of rate hikes and balance sheet reduction, the exact mix to be determined by evolving economic and financial conditions.

Bottom Line:  Dudley reinforces expectations that the low rate environment will persist long into the future. The data flow is not providing reason to think otherwise at this point; we would need to see higher inflation numbers coupled with real reason to believe labor market slack was rapidly evaporating, probably in the form of stronger wage growth. It remains interesting that the Fed does not view their own outlook as reason to accelerate the pace of activity. They seem relatively content to accept what they themselves acknowledge is an ongoing disappointment.

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