Where will the Fed’s virtue signalling (aka max employment target) take us?

Albert Edwards
+44 20 7762 5890
albert.edwards@sgcib.com
Global Strategy ‘Team’
Albert Edwards
(44) 20 7762 5890

It was clear back in July last year that the Fed was set to capitulate to those on both the left and right who had criticised its tightening cycle. And capitulate it has!

Last July, left-leaning Democrat Congressional representative Alexandria Ocasio-Cortez (AOC) took a direct shot at Fed Chair Powell during his appearance in front of the House Financial Services Committee. The Fed, she said, had consistently overestimated the ‘natural’ rate of unemployment and had hence tightened policy too early and too aggressively. Not only did Powell agree with AOC that the Phillips Curve relationship appeared to have broken down, but somewhat surprisingly President’s Trump economic adviser Larry Kudlow, a self-proclaimed supply side conservative, praised AOC for her intervention – link. The die was cast.

I’’ve had more than a weekend to mull over the Fed’s change in policy and reflect as to what this change in policy might mean for investors. In plain English, the essence of the Fed’s brand new policy is that it (the Fed) will keep its foot flat to the floor on the gas pedal, until it knows ‘maximum’ possible employment has been hit. It acknowledges that it would only know when the maximum employment rate has been passed in retrospect, by observing consumer prices beginning to accelerate well beyond its new 2% average inflation target. (previously the Fed would seek to return monetary policy to neutral as unemployment neared its own estimate of ‘natural’ rate of unemployment or the rate compatible with stable inflation – NAIRU).

Deflation is certainly the immediate threat for policymakers (see chart below). But in justifying the new “maximum employment” policy, Powell noted that as unemployment reached an historic low earlier this year, it delivered life-changing gains for many individuals, families and communities, particularly at the lower end of the income spectrum, with the gap between Black and Hispanic unemployment and that of white Americans falling to record lows.

This is true but using pathos as a justification for this major shift in policy is, in my opinion, virtue signalling at its worst. It is also dangerous as the new “maximum employment” target will inevitably further worsen – if that is possible – the type of financial market boom and deep bust cycle engendered by the Fed through recent decades. And we know when bust does inevitably occur, it is the poor and minorities who will suffer the most.

The widespread belief toward the latter end of the last economic cycle that one of the staple tenants of economics – that there was a clear if fluid relationship between lower unemployment and higher inflation – had broken down meant that the concept of trying to estimate and target NAIRU (non-accelerating inflation rate of unemployment) could be ridiculed as a ‘barbarous relic’ and consigned to the dustbin of economic history.

Back then, political pressure on the Fed had intensified from both the right and the left and a Congress threatened to legislate to force the Fed to explicitly target racial disparities in unemployment – the Fed clearly concluded that it had better get ahead of the curve.

Stephanie Kelton, one of the leading MMT advocates wrote recently, “Even as scientists innovate, creating new medicines, technologies & techniques to eradicate diseases & solve human problems, the majority of economists remain wedded to a fifty-year-old doctrine (NAIRU) that relies on human suffering to fight inflation”. (my underlining) Those of us who lived through the 1970s will remember this sort of rhetoric, i.e., attempting to guilt-trip and intimidate through pathos those who disagree with the MMT methods to reach the admirable objectives of full employment and lowering social and racial inequalities.

Stephanie Kelton’’s and to an extent the Fed’s call to target maximum employment on distributive grounds, were exactly the same siren Keynesian voices we heard in the 1960s to justify the targeting of ‘full employment’ – until it all fell apart in chaos. (I still remember in 1976, sitting in The Plough pub near where I lived in Kew Gardens, reading Milton Friedman’s latest IEA pamphlet on the augmented Phillips Curve. I was a very strange 15 year old!).

That same year one of my most vivid recollections was seeing the then Labour Prime Minister, Jim Callaghan, who had been close to the unions, give a speech to the 1976 Labour Party Conference. Above the booing and heckling he boomed, “We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.”

A left-wing Labour Prime Minister admitting that too much state spending was dangerous, while being jeered at by the massed ranks of his own party faithful, marked a massive turning point in Western economic policymaking and the final nail in the post-war Keynesian experiment of targeting full employment. Or at least we thought it had. But suddenly with one deft change in wording in a Fed policy statement, it is back! (For the avoidance of doubt I consider myself neither a Monetarist nor a Keynesian but see merit in both camps).

Long-time WSJ economic commentator Greg Ip last week noted that, “With the revamp of its monetary policy framework, the Federal Reserve has subtly but clearly shifted its priorities away from inflation to employment. The practical significance is small. With inflation already below the Fed’s 2% target and unemployment above 10%, interest rates were going to stay near zero for some years to come, and that hasn’t changed. But it’s an important institutional and philosophical shift. Like other pivots over the central bank’s 107-year history, this one comes in response to a changed world”.

Ip continues, “Central banks have long operated on the assumption that there is a trade-off between employment and inflation. As the unemployment rate drops below some “natural” level, inflation starts to rise, a relationship dubbed the Phillips curve. That means unemployment could be both too high or too low. The Fed in its old operating principles thus sought to minimize “deviations” of unemployment from this natural level. In practice, this meant the Fed had to both estimate the natural rate and raise interest rates if actual unemployment threatened to fall below it. The new framework replaces “deviations” with “shortfalls,” implying unemployment can be too high but never too low.” – link.

That point made by Greg Ip is simply massive, and the implications far reaching.

Certainly, there would have not been this shift in policy if the Fed – but also the ECB and BoJ –had not consistently failed to achieve its own projections of returning to 2% target inflation.

To an extent these were less forecasts of a return to 2% inflation and more a hope. Most certainly a central bank projecting it would fail to hit its own target would see it called a failure ex ante, with demands to be more aggressive than it might want. Instead the various central banks are called failures ex-post, but they can always come up with mitigating reasons why they failed to hit their 2% target; globalisation, strong currency, commodity prices, weather etc.

Our very own Stephen Gallagher points out that the Fed’s new, average inflation targeting over an unspecified timeframe gives it ultimate flexibility – allowing itself the option to re-set the starting point for the ‘average inflation’ calculation almost at will. (Read Steve’s excellent analysis here – link). This ambiguity about the time period for the Fed’s average inflation target was something picked up by Wolfgang Munchau a few weeks back in the FT. He made the very valid point that, if the Fed over-shot 2% inflation for many years at say 4%, would it be really credible that investors would believe it would drive inflation down to zero to compensate for this overshoot? The policy only holds water in the current circumstances of an undershoot.

Similarly James Mackintosh at the WSJ writes, “Those who prefer their monetary policy to be governed by rules will be disappointed. The Fed used to let bygones be bygones, ignoring what had happened to inflation in the past as it pursued its goal of 2% in future. A catch-up strategy
means that the failure to hit 2% for most of the past decade could be used to justify inflation above 2% for most of the next decade. The lack of a firm rule, though, means Mr. Powell isn’t tied to having to compensate for any future period above 2% by running below that afterward.

“Mr. Powell says the new approach is flexible. He isn’t kidding. Choose your period, and almost anything can be justified. Since 1960, inflation has averaged 3.2% (using the mathematically correct geometric, or compound, average of the Fed’s preferred inflation measure). A hawk applying a strict policy of inflation averaging could justify aiming for deflation for years to bring the long-term average back down to 2%. Some bygones will still be ignored (see chart below)”.

But does the consistent undershoot of the Fed’s 2% inflation target actually prove that the Phillips Curve is dead and hence justify this major revision of policy objectives that now puts the full employment target ahead of the inflation target? Maybe not. Indeed sub-2% US inflation is perhaps not so surprising or as unpredictable as some policymakers have made out. For example, the excellent Robin Brooks at the IIF seems perfectly able to model core PCE as it has twisted and turned below the Fed’s 2% target (see chart below, the core PCE is the Personal Consumption Expenditure deflator, which is the Fed’s official target rather than the CPI).

When AOC and friends were criticising Powell, the main thrust of their criticism was that wage inflation had not risen as quickly as would have been expected historically, given the record low rates in unemployment – so the Fed tightened monetary policy prematurely.

Yet it is difficult to find any economist who wasn’t perfectly aware that the historic low headline unemployment rate of only 3.5% massively understated the slack in the labour market due to the huge fall in the participation rate – a surge in discouraged workers no longer looking for a job who had dropped out of the Labour Force.

Clearly wage inflation seems to be lagging if one just looks at the headline unemployment rate (shown as the inverse in the left-hand chart below), and it looks as if the Phillips curve has, if not broken down, weakened considerably compared to history. However, if one includes the
discouraged workers and looks at the total working age population rather than the labour force, you can see from the right-hand chart below that the Phillips Curve relationship still holds firm.

I think it is totally wrong to believe that the Phillips Curve is dead, dormant or even flattened. There was simply more slack in the labour market than the Fed’s estimates of NAIRU at 5% supposed.

Measure unemployment correctly and the relationship still fits perfectly. So for the Fed to consign NAIRU to the dustbin of economic history just because of its own failure to consider that discouraged workers were holding down wages seems a total nonsense.

But even using the simple U3 unemployment rate and looking at the rate at which companies were increasing wages, I simply cannot see any breakdown in the normal Phillips Curve relationship.

And let us be clear. The howls of protests about Fed tightening in the last cycle were really about the direction not the absolute level of interest rates. The Fed was tightening policy but from an extremely accommodative stance. It was taking its foot off the accelerator but not tapping the brakes. Monetary policy was not as loose as previously but was certainly not tight. This is a key and important difference. A tight monetary policy would have slowed growth relative to trend growth. A return to neutral would not.

We can see how even when Fed Funds reached its 2.5% peak in the Summer of 2019, this was only considered long-term ‘neutral’ (right-hand column) by the Fed policy committee (see below, of course this 2.5% neutral long-term rate is just an informed ‘guess’).

So, after having been criticised for merely taking its foot off the gas pedal, the Fed has responded by putting the car into cruise control at top speed (see charts below). Repeating Greg Ip’s point, in the new Fed regime unemployment can be too high but never too low.

What could possibly go wrong?

Confirmation that the Fed was merely returning interest rates to ‘neutral’ in the last tightening cycle can also be found by looking at a reputable model estimate of the ‘natural’ rate of real bond yields (rather than Fed Funds). You can see how the real yield returned to neutral, only then to be driven into an extreme accommodative stance by recent Fed actions.

One doesn’’t even have to appeal back to 1976 revulsion against this Keynesian excess and the fact that the Phillips Curve is definitely not dead.

What makes me sad and indeed angry is not just that the Fed has resorted to virtue signalling to justify its new maximum employment policy by deliberately placing this in the context of closing unemployment inequality among racial and social minorities (the overwhelming majority
of economists would consider that reducing employment inequality has nothing to do with the blunt tools of monetary policy).

But even worse, the extreme monetary largesse the Fed has now embarked on in pursuit of it’s utopian ideals will merely exacerbate still further the massive wealth inequality that their policies of recent decades have already caused, with rampant financial and asset price inflation making the 1% even richer and thereby worsening rather than healing social division.

(If the process of achieving maximum possible employment and reducing racial and social disparities in unemployment were achievable without a car crash I would be all for it).

And then when the next inevitable financial market bust comes, the necessary (again!) aggressive bailouts of Wall Street at the expense of Main Street will further stick in the craw of the very people who the Fed claim it is trying to help. The unintended consequences of the Fed’s new more aggressive policies seem destined to make inequality worse not better.

Yet reading the comments of Fed members, particularly on Twitter, they apparently cannot conceive they are part of the problem. They oose overconfidence and arrogance and have learnt nothing from the disastrous outcomes of their repeated excessively easy money policies to
goose the financial markets and economy.

I leave the last word on the unintended consequences of Fed actions to the late, great Paul Volker who must be turning in his grave. He wrote in 2018 shortly before his death, “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk-taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about.”