The combination of a rapidly growing economy, and a surge in oil prices, has raised questions about the strength of the doves’ hand at the Fed. Previously in firm control, the doves had until yesterday been silent about the recent mixture of strong GDP growth and rising headline inflation. Was the case for exceptionally easy monetary policy beginning to fray at the edges? Not in the mind of New York Fed President Bill Dudley, who is among the most eloquent spokespersons for the dovish standpoint.
In an important speech, Bill Dudley confirmed that the US economy is now growing at an accelerating rate, but said that this reflected the success of Fed policy, rather than providing any case for changing it. He conceded that the structural unemployment rate may have risen to between 6 and 7 per cent, but argued that much of this increase may be temporary. And, in any event, he suggested that employment could rise by 300,000 per month for two years before the economy would run out of spare capacity. On the commodity price surge, he said that this would not be a sufficient reason for tightening monetary policy, unless it started to increase inflation expectations. Assuming this does not happen, Bill Dudley will remain an influential dove for a long time. And this is important, because his recent thinking has been very close to that of US Federal Reserve chairman Ben Bernanke himself.
There have been two significant challenges to the Fed’s dominant dovish tendency in recent weeks – the big drop in unemployment, and the rise in commodity prices. Bill Dudley considers both factors carefully, but concludes that neither is powerful enough to change his basic viewpoint on the economy.
To start with the labour market (which is discussed in detail in this earlier blog post), Mr Dudley starts by admitting that the structural unemployment rate may have risen by 1 per cent as a result of the extension of unemployment benefits, and by a further 0.5 to 1 per cent as a result of mismatches between labour supply and demand, and rising unemployment duration. But he says that the first of these factors will disappear when the extension of benefits is allowed to lapse, and that much of the second might also be reversed when the economy recovers. Consequently, he retains his very strong view that the economy continues to exhibit a very large margin of spare capacity.
This seems right. Consider the following graph, which shows the three main ways of assessing the margin of spare capacity in the economy: the output gap, the rate of unemployment and capacity utilisation in the manufacturing sector. (All are expressed as the difference from long term averages, measured in standard deviations.)
It is hard to argue with Mr Dudley on this. The output gap and the unemployment rate are still around 2 standard deviations away from their averages. Capacity utilisation may be a little tighter, because of the collapse in capital investment during the recession, but it is certainly not in danger territory. So why contemplate tightening monetary policy?
The most obvious reason is of course the rise in commodity prices, which central bankers are now realising will take headline inflation above 3 per cent fairly soon. But while this appears to be a reason for serious concern at the ECB, that is not obviously the case at the Fed. Mr Dudley does seem to think that part of the rise in commodity prices may prove permanent (because of the growth of demand from China and India), but he argues that the relatively low rate of core inflation in the US, and the relatively wide margin of spare capacity, will protect the low rate of inflation in the US better than elsewhere. But that does depend, he says, on ensuring that inflation expectations remain well anchored.
On that front, Mr Dudley may not be on such secure ground. Inflation expectations in the inflation protected part of the bond market have now risen from the subdued levels seen in mid 2010, so they are now back above the Fed’s 2 per cent inflation objective. It would not take much of a rise in inflation expectations to challenge Mr Dudley’s promise that “no-one on the FOMC (Federal Open Market Committee) is willing to countenance a sustained rise in either inflation expectations or inflation”. Maybe, but what exactly is meant by “sustained”? That is something which could be severely tested in the next few months.