US Monetary Policy Is Likely To Remain Loose For A While
With the economic cycle having hit bottom and turning, thanks in no small part to massive fiscal and monetary stimulus, attention is now turning to when that stimulus is likely to be withdrawn. For me, the likelihood is that tighter policy is going to be put off as long as possible by the authorities in charge.
My argument is that the Federal Reserve is unlikely to raise rates for awhile, until inflation starts perking up and unemployment begins turning down. So I’ve constructed an indicator: core CPI minus the unemployment rate (so low inflation and high unemployment make it unlikely that there will be rate hikes). Sort of the opposite of the misery index (which is unemployment + inflation). For you economics wonks out there, think of it as the Taylor Rule, simplified. See chart below.
Historically, this indicator and the effective Fed funds rate have moved closely. Pretty clearly, the high and rising unemployment rate, and subdued inflation, have created significant room for the Fed to maintain easy monetary policy in the current downturn. In fact, the gap of 8 percentage points between the Goldilocks index and the funds rate is the biggest since the series begins in 1958 (which was the last time the Fed funds rate hovered below 1%). Given that I don’t think unemployment has peaked (it is a lagging indicator, after all), or that inflation is going to be a problem for quite a while, the Fed is going to take things pretty easy well into 2010. There will be lip service paid to future inflation problems, but until this indicator begins to move higher, there will be plenty of excuses to keep rates low.