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Tuesday, December 20, 2016

Hamilton on the Fed: "Back to normal?"

by Calculated Risk on 12/20/2016 09:47:00 AM

A few excerpts from a piece by Professor Hamilton at Econbrowser: Back to normal?

A year ago, the Federal Reserve decided to raise its target for the fed funds rate by 25 basis points above the floor of 0-0.25% at which we’d been stuck for 7 years. FOMC members indicated at the time that they were expecting to end 2016 at 1.4%, or four rate hikes during the last year. We started this December at 0.41%, and the first hike of 2016 didn’t come until last week. Now FOMC members say they are expecting to end 2017 at 1.4%, or three more hikes from here during the next year. The January 2018 fed funds futures contract is currently priced at 1.23%, suggesting that the market is buying into two, not three hikes during 2017.
I like the visual device that Federal Reserve Bank of Chicago President Charles Evans proposed, which summarizes the Fed’s inflation and unemployment objectives in terms of a target with a bull’s-eye. I’ve centered the bull’s-eye below assuming a long-run inflation target of 2% and a natural unemployment rate of 4.8%. We’d like to be as close to the center of the target as possible. The U.S. has been moving steadily toward that objective since 2009, though up until the November employment report both the inflation and the unemployment data were arguing for more stimulus. This month for the first time the inflation number calls for more stimulus while the unemployment number suggests we may need less.

Hamilton Bulls EyeHorizontal axis: civilian unemployment rate. Vertical axis: inflation rate as measured by year-over-year percent change in implicit price deflator for personal consumption expenditures. 2017 entry represents FOMC projections. Crosses denote values for October unemployment and October year-over-year inflation for indicated year, with exception that 2016 unemployment number is for Nov 2016 and 2017 projection is for end of year. Adapted from Evans (2014).

If you took the bulls-eye literally, on net you’d still want to see some additional stimulus today, bringing unemployment even lower until inflation is closer to target. And in fact the Fed sees enough underlying strength in the economy that it thinks that, even with the rate hike last week and additional hikes planned for next year, on balance they’re still providing a modest stimulus and expect that by the end of 2017 we’ll end up very close to target ...

But the elephant in the room is of course the possibility that fiscal stimulus may soon be a factor pushing us in a northwest direction on that target. And that may soon come to play a bigger role in U.S. monetary policy determination.