University of Kentucky basketball coach John Calipari is known for his “one and done” style. The Federal Reserve finds itself in an awkward position with its monetary policy: only one hike left. Through a comedy of timing and awkward guidance, the Fed finds itself at the intersection of demographics and weak inflation. This is a position that will become all too familiar. The Calipari Fed should prepare to defend “one and done” monetary policy.
Chair Yellen and other members of the Federal Reserve policy setting committees have stated that the Fed is attempting to shift its monetary policy from stimulating the economy to being neutral. “Neutral” is where policy neither helps nor hurts the economy. And the current estimate of the neutral fed funds rate is around 1.25%. That is less than one hike away.
This dramatically contradicts the “dot plot” guidance from the Fed’s policy meetings. If its guidance were to be taken seriously (and it should not), four more rate hikes should be made by the end of 2018—not an unimaginable amount of tightening. But in light of the neutral rate, the dot plot guidance is an aggressive (having multiple rate hikes) and restrictive (moving rates above neutral) stance.
When the Fed guided toward a neutral policy, it tied itself to a far more dovish policy than the published dot plot would suggest. There are two sets of guidance with two radically differing monetary policy outcomes: the dot plot versus a neutral rate. This is why the Fed is now in a “one and done” situation. The neutral rate will win.
Why? For starters, if inflation declines by a modest amount, Fed policy could suddenly attain the neutral fed funds rate. More accurately the neutral rate would fall to the current fed funds rate. And that’s without hiking at all.
However, if inflation remains tightly range bound, there is still room for another hike. But it would be just that: one more hike. Not the four in the next year that the Fed is currently projecting on its dot plot.
Granted, there is the potential for the neutral rate of interest to increase. This would offer the Fed the opportunity to hike rates further. But we should not count on it to increase and allow the Fed an escape hatch to higher rates in the near term.
The neutral rate has been falling (with a few interruptions) for decades because of long-term shifts in the US economy. The usual suspects are to blame for the recent decline: slow productivity growth and demographics. Surprisingly strong productivity growth could push the neutral rate higher. But waiting for stronger productivity growth has been similar to waiting for Godot: always just over the horizon but never quite arriving.
This naturally leads to the question of whether or not the Fed can back away from its neutral policy target in favor of the dot plot. Probably not, because it is in the Fed’s best interest to maintain the neutral target. Moving rates above neutral is restrictive monetary policy. It would slow the economy and inflation further. Then the Fed would be running the risk of sparking a recession that it is ill-prepared to fight.
The Trump administration may appoint new governors to the Fed board. Maybe even a new Fed chairperson. Given this possibility, the neutral stance is attractive. It means no immediate need to hike following the transition. That would leave some room for the Fed to potentially dovishly surprise without changing its guidance.
But it also means the dot plot should be abandoned. It is useful only for understanding the Fed’s wishes. It wishes the neutral rate were higher. It wishes inflation would accelerate. It wishes productivity were stronger. The dot plot is simply fanciful economics.
One piece of the puzzle that remains largely unaddressed is the question of falling inflation. If inflation continues to fall, so too will the neutral fed funds rate. For example, if inflation were to fall toward 1.25%, that would dictate an interest rate cut to maintain a neutral stance.
That would be quite an interesting scenario. How reactive will the Fed be to these changes? In other words, there is a chance (though not highly likely) that getting to a neutral rate would dictate a decrease in the fed funds rate…not a hike.
What then does the Calipari Fed do? It needs to embrace the “one and done” rate hike and ditch the dot plot. The dot plot risks more credibility than it affords, and it has no basis in reality. Sometimes “one and done” really is the best option. And it gets the job done.