With the dual mandate in sight, the Federal Reserve should get monetary policy to a neutral stance, but that could be “challenging,” Federal Reserve Bank of Kansas City President Esther L. George said late Tuesday.
“[I]n my view, policy is still providing accommodation. Gradual further increases in our policy rate will be necessary to return policy to a neutral stance, although there is considerable uncertainty about exactly how far or fast we need to go,” George told a symposium at the bank, according to prepared text released by the Fed. “Thus, policy must thread the needle between moving too slowly toward neutral, which could lead to an undesirable increase in inflation, and moving too aggressively, which could precipitate an economic downturn.”
With full employment and price stability achieved, or nearly there, the economy doesn’t need to be stimulated or restrained, she said, “But navigating the path to neutral will be challenging.”
First, neutral is hard to pin down, so there is “uncertainty about how many policy moves it will take to return to neutral.” While a labor force that’s growing slower than in the past and sluggish productivity growth “suggest the neutral policy rate is lower than in the past,” other factors could partially offset those. “In addition, fiscal stimulus is likely raising the neutral rate, but it is not clear by how much,” George said.
The low level of unemployment, with no corresponding rise in unemployment “suggests that either the Phillips curve is unusually flat or, perhaps, obsolete,” she noted. “That said, monetary policy is currently testing the limits of how low unemployment can go without causing an undesirable increase in inflation.”
Quantitative easing also complicated policy. “I don’t dispute that some of these policies may have helped get us to where we are today. But now that the FOMC has largely achieved its objectives, he costs of these extraordinary policy actions are becoming apparent,” she said. “Even though we have begun to gradually normalize the size of the balance sheet, it remains exceptionally large by historical standards. It is still likely putting downward pressure on longer-term rates, working at odds with efforts to achieve policy neutrality.”
Also the Fed’s promise to keep rates low “has resulted in a policy stance that remains accommodative in the face of tight labor markets and inflation at the FOMC’s goal.”
As for the question of what an inverted yield curve will mean, George said, “It’s not clear how concerned we should be about this possibility.” She explained, “the Fed’s large holdings of Treasury securities may be keeping longer-term rates below where they otherwise would be and, therefore, distorting the signal from the yield curve.”
Because monetary policy works with a lag, and failure to take that into account “raises the risk of overshooting,” George said.
As a result, it becomes “increasingly” important that future policy decisions are based on data, “[a]nd given the policy lags, our actions need to be forward looking. In this context, data dependence means that policymakers should adjust their forecasts and associated policy paths as necessary based on the flow of incoming data. Therefore, I will be monitoring signs that might indicate whether we are nearing neutral or have further to go. For example, further downward movements in the unemployment rate or upward momentum in inflation would suggest to me that we have more work to do. On the other hand, stabilization of inflation and unemployment around their current levels might suggest less urgency for further policy action.”