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The Fed's Worrying Dovish Tilt

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The Fed's Worrying Dovish Tilt

March 17, 2016

As expected, at the conclusion of its FOMC meeting, the Federal Reserve maintained its quarter percent to half percent interest rate target. But what is surprising is the move to a more dovish monetary policy. This was conveyed by the language in the Fed’s Policy Statement; the FOMC members’ updated forecasts; and the members’ assessment of a much more gradual path of rate increases to a lower long-run rate.

Beyond the Fed’s concerns about international financial turmoil and the stronger U.S. dollar, the Fed effectively signaled that it has nudged its dual mandate targets. Think about it: the Fed has effectively achieved its dual mandate and the goals it spelled out in its official Statement on Longer-run Goals and Monetary Policy Strategy posted on its website. The unemployment rate has fallen to 4.9%, virtually on top of its estimate of the longer-run natural rate of unemployment. Inflation measured by the core PCE deflator has risen to 1.7%, very close to its longer-run 2% inflation target, and inflation pressures seem to be building.

The Fed cannot continue to tout that its policy is “data dependent” when recent data reflect that the Fed has effectively achieved its dual mandate, yet it doesn’t raise rates and indicates sustained extremely easy monetary policy.

With the modification of its dual mandate, this very activist Fed obviously is pursuing something more. It is basically saying that it aims to overheat the economy and that it will tolerate inflation above 2%, with the goal of further labor market improvement. Improvement includes both broader measures of unemployment—such as U-6, which includes workers that are designated as “marginally attached to the labor force” and “part-time for economic reasons”—and wage gains. In doing so, the Fed is understating the distortions it is generating and the higher risks of financial instability.

In its Policy Statement following its FOMC meeting, the Fed expressed concern about low inflation and inflationary expectations, even though core inflation has risen close to the Fed’s longer-run 2 percent inflation target. Market-based expectations of inflationary expectations have also risen. The Fed’s concerns about low inflation seem unwarranted, particularly since the Fed attributes the low inflation to earlier declines in energy prices that will not continue and that are helping the economy.

While the Fed acknowledges that “economic activity has been expanding at a moderate pace despite global economic and financial developments,” it identified those global economic and financial developments as a risk. This gave the Fed’s Policy Statement a dovish tilt.

The Fed’s updated economic forecasts seem odd and its outlook for inflation seems inconsistent with its underlying economic framework. The Fed modestly reduced its real GDP growth forecasts to 2.2 percent in 2016 and 2.1 percent in 2017 (both measured fourth quarter-to-fourth quarter). But even with these downward revisions, the Fed estimates that economic growth will exceed its 2 percent estimate of potential growth. With labor markets already tight, the Fed is forecasting that the unemployment rate will fall below the Fed’s estimates of the natural rate of unemployment.

Yet the Fed maintained its estimate that core inflation measured by the PCE deflator will be 1.6 percent in the fourth quarter of 2016, and it lowered its estimate to 1.8 percent for the fourth quarter of 2017. That means the Fed is forecasting that despite recent trends, by year-end 2016 inflation will tick down from its current level and be virtually the same as now at year-end 2017. The Fed reconciles this inconsistency by lowering its estimate of the longer-run natural rate of unemployment, signaling that it will be aiming to achieve lower unemployment. But keep in mind that estimates of the natural rate of unemployment are a guessing game, and the Fed has a track record of changing its estimates after the fact to provide a tighter fit in the wage and inflation equations in its macroeconomic model.

The sizeable reductions in the FOMC members’ assessment of the appropriate Federal funds rate associated with its economic and inflation forecasts reveal the Fed’s intention to maintain an extremely accommodative monetary policy. The median FOMC member now projects the Fed funds rate at 0.9 percent by year-end 2016, down from 1.6 percent in its December 2015 forecast, and 1.9 percent at year-end 2017. Keeping the inflation-adjusted policy rate at zero at that stage of sustained economic expansion, when inflation is presumed to be at the Fed’s 2 percent long-run target or perhaps higher, seems inappropriately easy.

So on the surface, a simple interpretation of the Fed’s meeting is “the Fed’s gradualism just got a lot more gradual.” A more detailed assessment is that in light of continued moderate growth in the economy and clear improvement in labor markets and recent rise in core inflation, the Fed has signaled its intention to maintain its extremely easy monetary policy. The goal is to pursue further labor market improvements that are beyond its dual mandate. That and the Fed’s excessive concerns about global turmoil and the U.S. dollar are worrisome and risky.


Mickey Levy is Chief Economist for the Americas and Asia, Berenberg Capital Markets, LLC and member, Shadow Open Market Committee.

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