Tim Duy summarizes the problem as the Fed sees it:
The Federal Reserve can’t catch a break on the inflation numbers, which are simply not helping in its drive to normalize monetary policy.
Monetary policy makers have three possible responses to the weak inflation data. First, they can define down the extent of an acceptable miss on their target. Second, they can dismiss the numbers as transitory and focus instead on full employment. Third, they can rethink their estimates of full employment and the subsequent implications for the path of interest rates.
Early indications are that the Fed will pursue some combination of the first two options. That means a June rate hike remains the best bet. But if inflation stays low into the latter half of this year, the Fed will eventually turn to the third option and adjust down the expected path of tightening. For the moment though, expect Fedspeak to dismiss this option.
There is an alternative, put succinctly by George Selgin:
While devising a monetary rule that strikes a correct balance between the supposed “wrongs” of price level movements on one hand and less than “full” employment on the other may ultimately prove as intractable a problem as squaring the circle, devising one that’s consistent with preserving a stable level of spending is, comparatively speaking, child´s play.
The challenge consists of getting both Keynesians and Monetarists, as well as others, to agree that stability of spending, rather than any particular values of inflation or unemployment, ought to be the ultimate objective of monetary policy.
The chart pictures the economy while the Fed managed to maintain a stable level of spending and the moment that stability was lost. It was clearly a monetary bungling by the Fed. Since then, the economy has been living through a “long depression”.
In the past few years, the Fed has engaged in very poor monetary management. In early 2014, coinciding with Yellen becoming Fed Chair, it raised the volume of the tightening talk. The immediate effect (no “long and variable lags”) was to make spending growth trend lower. That goes hand in hand with lower inflation expectations and lower real growth expectations, as indicated by the behavior of long-term yields.
In mid-16, given negative market expectations, the Fed “relaxed” monetary policy somewhat. Spending growth reversed direction. The rise in inflation expectations and long-term yields was, again, immediate. The election a few months later may have given those trends an additional push, but the main cause was monetary.
Now, the Fed has reverted to a “tightening stance” (at the same time that the “Trump Bounce” loses “punch”), so we´ll likely see the continuation of a falling trend in spending growth, long-term yields and inflation expectations.
Bottom Line: Tim Duy´s third option – a downward adjustment of the expected path of tightening – may take effect sooner than expected, even with June maybe “coming off the table”.
Addendum: Three years ago, James Bullard of the St Louis Fed constructed a measure of the Fed´s Objective Function, quadratic in the two blades of the mandate. In the chart, we see that the March data (April PCE inflation will only be released later this month) points to the Fed distancing itself from “nailing” its mandate.
In his latest speech, Bullard (a non-voting member this year) reflects that fact:
In discussing the FOMC’s March increase in the policy rate (i.e., the federal funds rate target), he noted that the financial market reaction has been the opposite of what would typically be expected. “This may suggest that the FOMC’s contemplated policy rate path is overly aggressive relative to actual incoming data on U.S. macroeconomic performance,” he said.
With the U.S. unemployment rate at 4.4 percent, Bullard also examined the relationship between unemployment and inflation and whether the current low unemployment rate may signal a meaningful increase in inflation. “Low unemployment readings are probably not an indicator of meaningfully higher inflation over the forecast horizon,” he said.
We can only hope his views become consensus!