• Warning, this note is a touch (or much) more technical than most. However, it (hopefully) lays out the monetary policy consequences of Powell's Pivot to an employment first policy.
  • The consequences are more consequential than commonly acknowledged. One implication is that monetary policy will be much looser for longer with "unconventional tools" - QE and the like - being utilized for longer. 
  • To show how this works, a simple monetary policy rule is laid out in the vein of the infamous "Taylor Rule". 
  • With a low neutral fed funds rate, a de-emphasis of inflation overshoots and a focus on the employment, monetary policy will highly stimulative for a long, long time. 
“Economy is not baseball, where the game is always played by the same rules.”
― Nate Silver, The Signal and the Noise

The Fed made an important pivot yesterday. While "average targeting targeting" is getting all the headlines, it doesn't really matter. The Fed wanted inflation during the last cycle and never got it. Therefore, it is difficult to see how acknowledging the Fed's "inflation wish" changes anything. The only informational content the average inflation target contains is that the Fed will wait for realized inflation instead of raising rates ahead of it. That is all. 

The true content of yesterday's Fed framework review release was the pivot to an employment first framework. "Employment shortfalls" can be simply defined as the differential between the unemployment rate and the maximum employment rate. This is what economists refer to as u* or the estimated minimum level of unemployment (maximum employment) that does not spark inflation. The Fed's lack of ability to hit the inflation target is widely mocked, but it's consistent undershoot of maximum employment gets little attention. 

As noted here, u* has been falling, and that decline has caused trouble for policy makers. The Fed's revisions to the "Longer-Run Goals and Monetary Policy Strategy" attempt to address this complication. 
How this pivot changes the direction, delivery, and nuances of monetary policy going forward is the question that really matters. To garner an understanding of the implications of the pivot, there are a few things to note about the Fed's announcement yesterday. 
  1. Average inflation targeting created a dynamic where the Fed will tolerate moderately higher inflation in exchange for employment gains. Therefore, inflation will now only be counteracted by Fed policy when employment is near the maximum. 
  2. This causes inflation to act as a "state dependent" stop. If inflation rises to 2.5% early in a recovery due to base effects, the Fed is not going to care.
  3. The acknowledgement that the "neutral rate" - the fed funds rate where policy is neither stimulative or contractionary - is very low.
Taking all of this into account, a "policy rule" of thumb can be constructed.  
The Taylor Rule is a fairly straightforward method of calculating a monetary policy rule for how policy should be conducted given a set of inputs. The rule consists of the nominal neutral rate, and the output gap for GDP. The output gap can be converted to the unemployment gap. But, given the Powell Pivot, this step can be skipped in favor of simply using the estimated employment shortfall using predictions from the Congressional Budget Office.

Traditionally, inflation and employment are given equal weights within the model. With the switch to a employment first framework, that should not be the case. The model also assumes that the nominal neutral rate for Fed policy is 0.5%. This is used to avoid the tightening bias inherent in the base model, and compensate for the downward skew to the estimates of the neutral rate. Not to mention, that is within the current range of estimates for the nominal neutral rate and could in fact be too aggressive. The lower bound estimate by Lubik and Matthes for real neutral rate is 2.8%. With the neutral rate falling, it is reasonable use a lower figure. 
So, the "Fed's New Rule" is more aggressive on the employment front without much of a shrug from inflation. That makes sense, and it can be calculated simply.

Policy rate = 0.5% + [0.5 x (inflation - inflation target) ] + [1 x (employment shortfall)] 

The 0.5 and the 1 represent the weight placed on the inflation and employment variables (and yes, they can sum to greater than 1). 

With this in place, there can be an assessment made about what this pivot would have meant in the past, and it could mean in the future. Following the financial crisis, the new rule indicates a Fed path of rates not dissimilar to the shadow rate until late in the recovery. With the new rule, the Fed would have waited until late 2017 or early 2018 to raise rates. In reality, the Fed first hiked rates in late 2015. That is a two year differential in the beginning of the tightening cycle. 
What does the new rule say about the future? It is all about the employment shortfall. Using the CBO's estimates, it indicates some tightening begins in the middle of 2028. That seems to be extreme, but COVID was a much larger hit to the labor market than the financial crisis. And the Fed began cutting in mid-2007 and did not raise rate until late 2015 (and this rule points to that being premature).The duration of the cycle predicted is only a touch longer from the first cut earlier this year to mid-2028.  Critically, the recovery in employment will shape the curve. Any hiccups or slowing will push the "belly" down and the expected length of the easing cycle out. 

While everyone was looking at "average inflation targeting", the Fed pulled a fast one. There is a new rule, and it says the Fed will be easier for longer. It also implies more to come from the Fed to ease and stimulate. Given that rates are already at 0, it will need to come in the form of unconventional policies and strong forward guidance. Those are the only ways to keep the shadow rate below 0.

The Fed's playbook looks the same, but it is playing by a new rule.

As always, please do not hesitate to reach out with comments, questions, or suggestions.

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Samuel E. Rines
Chief Economist
Avalon Investment and Advisory 
Direct: 713-358-6077
2929 Allen Parkway, Suite 3000
Houston, Texas  77019


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