The Silence Of The Doves
As the Fed scrambles to rebuild its anti-inflation credibility, hawkish voices dominate. James Bullard suggested a 75 basis points hike should not be ruled out; Chairman Jerome Powell said a 50 bp hike will be on the table next month; Lael Brainard, never mistaken for a hawk before, said bringing inflation down “is of paramount importance” and the Fed will start shrinking its balance sheet at a rapid pace.
The doves are quiet. They should be. Last July, as inflation surged to 5 ½ %, they argued that tightening policy would have been premature – it clearly wasn’t.
The silence of the doves underscores the Fed’s credibility challenge. The central bank spent the last ten years reassuring markets it would never tighten too much, too soon or too fast; it committed to staying behind the curve with a new monetary policy framework; and kept insisting inflation was temporary long after price increases had overstayed their welcome.
And yet the biggest problem is not the Fed’s hard-earned dovish reputation. It’s that the Fed has reset the markets’ notion of what tight monetary policy looks like.
After the latest bout of hawkish noises, markets expect four 50-basis points hikes over the next four policy meetings. That’s a lot compared to previous expectations, and sounds aggressive after rates have been resting for so long at the zero bound.
But it would bring the policy rate at only about 2.5% by end-September. Inflation is at 8.5%. Even if the monthly pace of price increases slows significantly from the 0.7% average of the last twelve months – say to just 0.4% month on month – September annual inflation would still be at 7.5%, three times higher than the expected policy rate. And in the Fed’s current view, the rate hike cycle would be almost over: the latest “dot plot” shows a median peak rate of 2.75% in 2023.
There are two key assumptions buried in here. Both show that while silent, the doves still carry huge influence. And both are deeply misguided, in my view.
First: the Fed assumes that inflation will come back to target even if real interest rates remain negative all along – and deeply negative for a prolonged period. That’s suspiciously close to arguing that inflation is “temporary”, even though the Fed no longer says that out loud. Maybe with fiscal policy a little less reckless, geopolitical shocks and higher prices will slow the economy enough to cool off price pressures. Maybe. Or maybe we’ll end up with a period of stagflation. The Fed has put itself in an unenviable position: if it tightens too much it could precipitate a recession; if it moves too gently, high inflation might become entrenched. But it’s unlikely that it can bring inflation back to target without pushing nominal interest rates above inflation.
Second: the Fed assumes the real equilibrium interest rate (r* in economics jargon - defined as the rate at which monetary policy is neither expansionary nor contractionary) is somewhere around 0.5%. Remember the “r-star” debate? Econometric analysis (see for example here) suggested that after the Global Financial Crisis the equilibrium real rate of interest dropped by about 2 percentage points. Explanations centered on higher demand for safe financial assets like US Treasuries, driven by central bank purchases (Quantitative Easing) and higher emerging markets savings, and lower productivity growth. If the real equilibrium interest rate is as low as 0.5%, then once inflation comes back to 2%, a nominal policy interest rate of 2.5-2.75% would be about right. But the conditions that seemed to support such a low equilibrium interest rate are on their way out: The Fed is pondering how quickly to shrink its balance sheet. Productivity growth has rebounded (see below). And the prima facie evidence that near-zero real interest rates were consistent with low inflation…well, that’s gone.
Before the global financial crisis, r* was around 2.5% - and US productivity growth averaged 2.5% during 1991-2007. After the GFC, during 2010-18, US productivity growth dropped to a lackluster 0.9%. But now it has rebounded, and averaged 2.4% over the past three years.
(Non-Farm Business Sector, Output per Hour, All Employed Persons; Source: BLS)
Productivity numbers can be volatile, and the last three years have been unusual, but that’s where we are; and there’s no doubt that companies have been innovating fast to boost efficiency and productivity in the face of repeated shocks and rising cost pressures. So with QE going out of fashion and productivity rebounding, r* might well be headed back to 2-2.5%. In which case the equilibrium nominal policy rate, with inflation on target at 2%, would be around 4 ½ %.
The Fed thinks the equilibrium policy interest rate is about 2 ½ - 2 ¾ %, and that reaching it will be enough to curb inflation. Markets have accepted this “hawkish pivot”, with some pain. But the equilibrium policy rate might be a couple of percentage points higher, and bringing inflation under control might require going beyond it. The silence of the doves might last a while.