Growing up, I was a huge fan of the Olympics. Winter Games, Summer Games, it did not matter. My eyes were glued to the TV screen. I recall particularly enjoying gymnastics, especially watching the dismounts. As the gymnast spun through the air towards the mat, I was filled with suspense ‑ would he or she “stick the landing”, that is, land perfectly without feet moving after impact?
The expression “stick the landing” popped into my head the other day as I thought about the next few years for US monetary policy, now that a December lift-off appears highly likely. When I look at the Federal Open Market Committee (FOMC)’s projections for the federal funds rate, inflation, and the unemployment rate, it strikes me that the Committee is attempting to stick the landing. The Committee projects that by gradually raising rates, it can slow the economy over time and by just enough to return inflation to 2% without jeopardising growth or the health of the labour market. The challenge of sticking the landing becomes clear when considering the projected path for the unemployment rate, using the median projection from the September 2015 Summary of Economic Projections (SEP). The Committee anticipates only an additional two-tenths decline in the unemployment rate over the next two years, despite the fact that the unemployment rate has fallen by about one percentage point per year over the last three years (see Exhibit 1 below).
Exhibit 1: A perfect landing
Source: Bloomberg; Summary of Economic Projections, September 2015
Core PCE = personal consumption expenditures (PCE) excluding food and energy
What probability can one reasonably assign to this outcome after such sharp declines in the unemployment rate over recent years, and how can the Committee expect to bring it about with only modest changes to the policy rate? A large part of the answer lies with estimates of the current equilibrium federal funds rate, the rate consistent with full employment and 2% inflation. Most frameworks for estimating the real equilibrium rate place it at no more than 1% currently, and an approach developed by Thomas Laubach and John Williams, the President of the Federal Reserve Bank of San Francisco in “Measuring the Natural Rate of Interest” (2001) , estimates the equilibrium rate to be slightly below zero at present (see Exhibit 2 below). Depending on what inflation measure one uses, the actual real policy rate presently sits at around ‑1%, not far below estimates of equilibrium. Thus, even gradual increases in the policy rate should theoretically be sufficient to prevent overheating of the economy. And tightening of financial conditions over the past year, including a stronger US dollar and wider credit spreads, should also restrain growth. The key point is that the Committee seeks to bring about over the next two years a slowdown in jobs growth closer to a rate consistent with growth in the labour force, about 100 000 jobs per month. Another possibility is that jobs growth remains quite strong, but a rise in the labor force participation rate keeps the unemployment rate from falling much below the non-accelerating inflation rate of unemployment (NAIRU). But after years of incorrectly projecting a rise in the participation rate, this no longer appears to be the Committee’s baseline forecast.
Exhibit 2: Equilibrium real policy rate estimate
Source: Federal Reserve Bank of San Francisco; Summary of Economic Projections, September 2015
Note: Projected path of the equilibrium policy rate based on author’s calculations, assuming rate rises gradually to the median Committee participants’ estimate of the longer-run policy rate, adjusted for 2% inflation.
These projections for the path of the economy are not wholly unrealistic. Still, sticking the landing after years of monetary gymnastics will be extremely challenging. A lot will have to go right. The Committee will need to arrest the pace of progress in the labour market without damaging the economy. And if its estimate of the current equilibrium policy rate is too low, preventing inflation from rising above 2% could require a steeper adjustment to policy rates than the median path reflected in the SEP. On the other side of the ledger, global headwinds and a stronger US dollar could continue to weigh on growth and inflation, making it difficult for the Committee to sustain even a gradual path of tightening. Hopefully, the Committee can channel its inner gymnast, creating financial conditions that perfectly balance upside and downside risks to the economy. But these challenges imply that the course of policy will likely be much less certain and more variable than what is projected in the SEP.