Analysis: What will the Fed do with an overshoot?
Officials see unemployment dropping to 3.5% by late 2019, below their long-term estimate
The Federal Reserve’s dilemma is intensifying: When has the economy had too much of a good thing?
In forecasts released at the end of their meeting Wednesday, Fed officials again raised their projections for economic growth, and lowered their projections for unemployment.
They now see the jobless rate dropping to a 50-year low of 3.5 per cent by the end of next year, a full percentage point below their estimate of where unemployment should be in the long run (the so-called natural rate, below which inflation accelerates).
By any estimate, that is a huge overshoot, and one that implies that by 2020 the economy will be well into overheating territory, the sort of situation that usually leads to dramatically higher interest rates and a recession.
Fed Chairman Jerome Powell, asked about this during his press conference Wednesday, cautioned against assuming that gap means joblessness must eventually go back up, noting estimates of the natural rate of unemployment have already dropped a lot, and could presumably drop further.
“I would emphasize we are learning about the real location of the natural rate of unemployment as we go,” he said, adding, “We can’t be too attached to these unobservable variables.” (He was referring to the fact the natural rate can’t be measured, but rather only inferred from how the economy and inflation behave.)
That’s not an entirely satisfying answer. Officials’ estimates of the natural rate have dropped in the past two years, but their projection for unemployment by the end of 2019 has dropped even more, and even that may prove pessimistic if the usual relationship between unemployment and economic growth holds.
So while officials may be agnostic on the precise natural rate, all of them are building an overshoot into their projections.
This is also apparent from the fact their median forecast for inflation in 2018, 2019 and 2020 is 2.1 per cent, marginally above the Fed’s 2 per cent target. Mr. Powell played down the significance of that overshoot, suggesting the Fed would not “overreact” to it.
But this answer is also unsatisfying. The Fed can’t realistically move inflation much this year or next given the lags in monetary policy, but by 2020, it can. It could in theory raise interest rates by enough to slow the economy and cool the labour market so that inflation is 2 per cent instead of 2.1 per cent in 2020. That they are not planning to do this suggests they think it would be too disruptive. It also suggests the “Phillips curve,” which predicts inflation rises as unemployment falls, still exists, even if it’s flattened.
But that only postpones, it doesn’t remove, the day of reckoning; so long as unemployment is below its natural rate, inflation will tend to go up, not down.
For these projections to make sense, Fed officials must either raise their inflation target, assume some serendipitous boost to the economy’s potential growth rate or decline in the natural unemployment rate, abandon their economic models or run much tighter monetary policy, especially after 2020.
For now, this last option seems the likeliest. On Wednesday, officials took a small step in that direction by signalling two more rate increases this year after the one announced Wednesday, for a total of four. That’s up from the total of three they pencilled in at their March meeting. Similar upgrades may be in store.