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William Lee
Chief Economist
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William (Bill) Lee is chief economist at the Milken Institute. He leads the Institute’s effort to develop collaborative policies to improve access to and the functioning of capital markets, strengthen financial stability and the soundness of financial institutions, and foster global macroeconomic, financial, and regulatory conditions to bolster job creation.
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What is on the Mind of FOMC Members?

By: William Lee
May 24, 2017

Lee discussed challenges facing the FOMC on Bloomberg TV's "What'd You Miss?"on May 24, 2017

The Federal Open Market Committee (FOMC), which tomorrow will release minutes from its May 2-3 meeting, faces a dilemma:

Do they stick with their plan for three rate increases in 2017 while beginning to reign in their balance sheet by year-end? Alternatively, do they delay some aspect of interest rate normalization once more?

The most important, and apparently contradictory, developments challenging the FOMC’s plan to normalize interest rates are:

  • The incipient inflation slowdown ahead, which will keep inflation well below the Fed’s forecast trajectory through 2018
  • Inflation will slow despite the drop in the unemployment rate in April to 4.4 percent (well below the FOMC's year-end 2018 forecast and their estimate of the natural rate)

Recent data imply a possible delay in reaching the FOMC’s inflation target. Soft core-CPI inflation data released in April imply a year-on-year inflation rate of approximately 1.4 percent — substantially lower than the 1.8 percent pace seen a couple of months earlier.

To be sure, the FOMC’s latest projections (done in March) imply an inflation trajectory that does not rise above their 2 percent target until 2019. However, they also project inflation to rise steadily as the unemployment rate declines to near 4.5 percent (below most FOMC participant’s estimate of the natural rate) by the end of 2018. Yet the April labor market data showed that the unemployment rate dropped at an even faster pace: it dropped to 4.4 percent in April. This development would normally raise their inflation forecast. 

The Unemployment Rate is a Lousy Indicator of Labor Market Slack

The standard Phillips curve model for forecasting inflation has malfunctioned because demographic and other developments slowing the growth of the labor force have made the unemployment rate a poor indicator of slack. Moreover, the underemployment rate remains above pre-crisis levels (with the U6 measure still at 8.6 percent, well above the 8.0 percent level seen in 2006-2007) even as the unemployment rate itself (U3) has reached pre-crisis levels. The volatility in the labor participation rate as the economy improves shows there may remain substantial slack to contain inflation even as employment growth picks up.

In addition, there is little evidence that employers are bidding up wages at an accelerating pace because the hiring rate has not kept pace with the rise in job vacancies. The following chart shows that while job openings are reaching historically high levels at very low unemployment rates (left side), the ratio of hiring to job openings is at a historically low level (right side). This implies that firms are aggressively shopping for better workers to upgrade their workforce. Nevertheless, they have not hired aggressively because with the high degree of uncertainty ahead for fiscal policy and no signs that growth (e.g., sales) will rise in the near future — they can delay hiring until they find the “perfect worker” at the “perfect (low) price.”  

More Selective Hiring—Hiring Lags Vacancy Growth

More job openings for given unemployment rate → more skills mismatch + more selective hiring because increased uncertainty about robustness and durability of expansion.

Fig. 1 - Beveridge Curve Remains Shifted Out Vacancy Rate Higher for given Unemployment Rate 2000 - Present


Fig. 2 - Low Hires to Job Openings Ratio Means No Wage Pressure as Nonfarm Productivity Rises Slowly


Source: Bureau of Labor Statistics and Citi Research.

Concluding Thoughts: Maybe Delay Balance Sheet Reduction Until Next Year?

Macro conditions warrant slowing the pace of interest rate normalization and/or delaying the timetable for balance sheet reductions. Market participants expect the FOMC to taper the pace of securities purchases to slow the growth of the balance sheet (and eventually reduce its size) by year-end. However, there is no rush to begin tapering the pace of purchases this year. The inflation outlook likely will remain benign because the substantial slack in the labor market and the cautious pace of hiring will dampen incipient inflation pressures for some time.

Moreover, it makes sense that the FOMC may favor continuing a steady pace of interest rate increases without the additional tightening from balance sheet reductions. This is because the impact of rate increases on the real economy (and financial markets, including the exchange rate) is easier to calibrate than changes in the size of the balance sheet.

Indeed, there is no reason why the Fed’s balance sheet should not remain at its current size or even be allowed to grow at the same pace as the economy. That would allow the policy rate to rise further than otherwise. This would alleviate much of the portfolio distortions imposed on global financial markets from a decade of low and near-zero rates. Indeed, such a revised normalization policy would alleviate many risks to financial stability.

Opinions expressed are solely those of the author and do not express the views or opinions of  the Milken Institute