GS Stock: In a midday Tuesday note Street Insider received, Goldman’s top economist Jan Hatzius runs the math on whether the Fed is behind the curve in raising rates and the implications this should have on our collective psyche. There is not question that the current policy of the Fed is “too easy”. That is apparent to those who utilize the Taylor Rule and those who monitor general market behavior.
Looking at historical standards, it is clear the current Fed policy is way too easy:
Even if the Fed is behind the ball on raising rates, Hatzius believes we are “probably not” going to see “out of hand” inflation. Phew!
“How plausible is it that current Fed policy is really too loose, as implied by Exhibit 1? The continued easy setting of financial conditions lends support to the message from the policy rule. Our FCI remains easier than average and our estimate of the FCI impulse to growth is still nearly +0.5pp for 2017 at a time when growth is already above trend and the Fed is close to its mandate and trying to impose deceleration. If the Fed is behind, what would it take to catch up? Last week, we showed that the Fed’s projections over the next few years already correct the modestly “too easy” stance implied by its depressed r* view. Under the alternative assumption that critics of the low r* thesis are right and a 2% neutral rate is a better guide, current policy is about 3.5pp too easy and the Fed’s terminal rate estimate about 1pp too low, requiring 1 additional hike per year beyond those already planned to catch up by 2020. Would inflation get out of hand if the Fed were that far behind for that long? Our earlier research on the inflation consequences of policy mistakes suggests probably not. Even if the slope of the Phillips curve and the adaptiveness of inflation expectations were twice as large as assumed in the Fed’s FRB/US model, inflation would only overshoot by about 0.4pp, a meaningful but certainly not explosive rise.”
So how does the current state of affairs relate to the mid-1960s?
“The main lesson we draw from the mid-1960s is that the Fed lost control due to the combination of heavy political pressure and a Phillips curve that proved sharply nonlinear at very low unemployment rates. Such an outcome seems less likely today, in part because inflation expectations are likely better anchored on the Fed’s target and the Phillips curve is likely flatter,. and in part because there appears to be little appetite on the FOMC for very low unemployment rates. While Yellen briefly pondered the merits of a “high-pressure economy” last year, the idea has been notably absent from the policy discussion this year, presumably due to a lack of enthusiasm from other FOMC participants.”
But in the end, “the Fed is modestly to moderately behind the curve”:
“Overall, standard policy rules suggest that the Fed is modestly to moderately behind the curve, but not to a degree that is comparable to the largest policy errors of the past or that could not be rectified by moderately faster tightening. But the experience of the mid-1960s—a time when a sudden spike in inflation would have seemed similarly implausible—suggests some caution is warranted.”
THe article first appeared in streetinsider.com