· However, the FOMC made explicit what had previously been implicit—the specific “economic conditions” it had in mind. In particular, the statement referenced “low rates of resource utilization, subdued inflation trends, and stable inflation expectations” as reasons for policy to remain very easy.
· What indicators should investors watch to judge whether these conditions remain in force? For resource utilization, the broadest measure is the overall “output gap” between actual and potential GDP – but in practice the unemployment rate may be more important as a measure of utilization. For inflation trends, core inflation – particularly the PCE measure used by the Fed in its forecasts – is most important. And for inflation expectations, Fed officials are probably looking at a range of measures, most importantly market-implied expectations of future inflation (i.e. the five-year, five-year forward TIPS spread) and longer-term household expectations (including the University of Michigan’s median five-to-ten-year measure).
Today’s policy statement from the Federal Open Market Committee (FOMC) retained language suggesting “economic conditions…are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” as we and most other market participants had expected. For most observers, this language was the main focus headed into the meeting – a significant change would have been taken as a hawkish signal that Fed tightening was nearer at hand than many had supposed.
Still, the FOMC did tinker with the statement in a number of ways. First, it recognized that economic activity “has continued to pick up,” and referred to consumer spending as “expanding.” rather than “stabilizing” as in the prior statement. Second, it trimmed the size of the agency debt purchasing program to $175 billion from $200 billion, but downplayed this move as “consistent with the recent path of purchases” and motivated in part by “the limited availability of agency debt.”
Most importantly, however, the FOMC made explicit what had previously been implicit—the specific “economic conditions” it had in mind that warrant exceptionally low rates. The forward-looking statement about interest rates now references “low rates of resource utilization, subdued inflation trends, and stable inflation expectations” as reasons for policy to remain very easy.
As we noted in a comment immediately following the statement, the mere fact of this change could be taken as a sign that the committee has opened the door just a touch to future rate hikes. But the change is open to competing interpretations, which may be what eventually led to its adoption. To us the amplification seems straightforward, as most economists would include resource utilization, inflation expectations, and inflation itself on a short list of the economic conditions the committee originally had in mind. For those committee members who see these variables as extremely low, the statement might actually seem like a stronger commitment to keep the funds rate low, but obviously others will see matters quite differently.
In any case, it is useful to consider what specific indicators FOMC members may have in mind as they consider whether “low rates of resource utilization, subdued inflation trends, and stable inflation expectations” remain in force. Current values of these indicators are shown in the table below, with the most important indicators (in our view) in bold text.
1. Low rates of resource utilization. The broadest measure of resource utilization is the output gap – the difference between actual and potential GDP. The Congressional Budget Office, the definitive source for estimates of potential GDP, currently estimates the gap at 6.3% as of the end of the third quarter, the largest since the early 1980s. (The gap shrank marginally in Q3, since the economy grew above trend last quarter.)
However, the output gap is a nebulous, difficult-to-measure concept and many analysts view it with skepticism. An alternative is to review more “‘micro” measures of resource utilization, a few of which are included in the table below. (A more extensive table is provided as Exhibit 5 of “Deflating Inflation Fears,” GS Global Economics Paper No. 190, September 29.) Of these, we view the unemployment rate as most important. It is a widely accepted surrogate for the GDP gap, it carries significant socioeconomic implications, and it is one of four indicators for which Fed officials provide public forecasts on a regular basis (the others are real GDP, core PCE inflation, and headline PCE inflation). At 9.8% as of September, the unemployment rate is nearly three standard deviations above its average level of the past half-century.
2. Subdued inflation trends. The use of the word “trends” in the statement hints at core inflation as a more prominent metric than headline, though a few FOMC members might take issue with that interpretation. Historically, current core inflation has tended to be a better predictor than current headline inflation of future headline inflation (see “The Case for Core,” GS US Economics Analyst 07/28, July 13, 2007). In the short term, this is a distinction without a difference, as headline metrics show deflation over the past year and core inflation is on the soft side of desired levels. However, the distinction is likely to matter much more in 2010: headline inflation will rise well into positive territory in coming months as year-over-year comparisons become “easier”, while (after perhaps a slight increase in the remainder of 2009) we expect core inflation to decline further in 2010. The Fed forecasts price indexes for personal consumption expenditures (PCE) rather than the consumer price index, so we see the core PCE inflation metric as the most important.
3. Stable inflation expectations. A significant increase in inflation expectations could push the Fed to tighten even if actual growth or inflation remained on the weak side. In fact, a big move in inflation expectations in either direction would probably trump other indicators in terms of the influence on Fed policy. A case in point is the sharp decline in market-based inflation expectations in late 2008, which coincided with much more aggressive Fed rhetoric (including the statement that the FOMC would use “all available tools” to restore growth) and actions (the initiation of asset purchases in late November and expansion in March).
In our view, the most important indicators of inflation expectations are longer-term measures of breakeven inflation (the difference between the yields on nominal and inflation-protected Treasury securities; inflation swaps provide a slightly ‘purer’ alternative metric with fewer liquidity issues) and household expectations of inflation. In the case of breakeven inflation, the five-year, five-year forward measure is commonly used. In the case of household expectations, the longstanding University of Michigan measure of median 5-10 year inflation expectations is probably foremost.
After these two measures, the next is probably the long-term inflation expectations captured in the Philadephia Fed’s Survey of Professional Forecasters. We view forecasters’ expectations as slightly less important, as they generally lag a bit and the channels through which they affect actual inflation are less direct. In any case, longer-term market-based expectations are slightly above their average of the past few years while survey-based inflation expectations are slightly below. In short, inflation expectations are low and fairly stable at the moment.
Some Fed officials may also view the value of the US dollar or commodity prices (particularly gold) as containing information about inflation expectations, or about future inflation. It is more difficult to calibrate exactly how “out of whack” these variables are, and we very much doubt that they alone would prompt a change in Fed policy. However, large moves might be a contributing factor to a change in rhetoric if they accompanied modest changes in market- or survey-based measures of inflation expectations.
Key Measures of Resource Utilization, Inflation, and Inflation Expectations
| Criteria for "exceptionally low" rates | Current level (%) | Long-term avg.* (%) | Deviation** (std. dev) | |||||
| Low resource utilization | ||||||||
| Output gap | -6.3 | 0.0 | -2.4 | |||||
| Unemployment rate | 9.8 | 5.9 | -2.7 | |||||
| Housing vacancy rate (year-round) | 10.9 | 8.0 | -2.3 | |||||
| Industrial capacity utilization | 70.5 | 81.1 | -2.7 | |||||
| Subdued inflation trends |
