Time to Run the U.S. Economy a Little Hot?

Following another underwhelming U.S. CPI report, it’s now entirely possible that core personal consumption expenditures (PCE) inflation – the Federal Reserve’s preferred measure, currently at 1.5% – will end the year at 1.3%, a far cry from the central bank’s 2% target. Against this backdrop, the Federal Open Market Committee’s (FOMC) 1.7% median forecast for year-end PCE inflation (revised down from 1.9% only in June) increasingly looks like wishful thinking and will likely have to be revised lower yet again in the September projections.

Dovish turn looks more likely

With inflation continuing to underwhelm, odds are also growing that come September, the FOMC will throw in the towel on the additional rate hike that the majority of participants have penciled in (according to the “dot plot”) for the remainder of this year. The FOMC could justify its plan to delay further hikes by citing the need to wait and see how inflation develops or the need to minimize any negative market impact from the likely September announcement that a gradual reduction of the $4.5 trillion balance sheet will commence in October (though this should be largely priced in by now).

However, a dovish adjustment of the Fed’s projected rate path in September is nowhere near a done deal. This is because a majority of FOMC participants continue to believe in the Phillips curve and thus in an eventual pickup in wage and price inflation if unemployment is allowed to drop far enough.

I have several issues with this argument:

  • For starters, nobody can definitively state the magical level of unemployment below which wages start to accelerate sharply (in economists’ jargon, the non-accelerating inflation rate of unemployment, or NAIRU). The Fed, along with everybody else, has repeatedly had to revise its estimate of the NAIRU lower, and another such revision appears to be in order for September. True, unemployment is down to the lows reached in previous cycles. However, the lack of wage pressures suggests that significant slack may still be hidden in the labor market.