FedWatch: Is 'optimal control' about to be tested?


Oh, to be a fly on the wall at next week’s deliberations by Fed policymakers. While nothing much is expected from the two-day policy-setting Federal Open Market Committee (FOMC) meeting that ends next Wednesday, one can almost bet that at least some of the discussion will focus on what policy wonks call “optimal control,’’ a modeling approach that seeks to minimize the deviation of the Fed’s key variables—inflation and unemployment—from their presumed “target” levels. I know, sounds boring.

But what makes this interesting are speeches and comments about “optimal control’’ from Fed Chair Janet Yellen in the year before she became chair. In effect, Yellen suggested it may be preferable to manage the Fed’s policy to produce the combination of economic growth and inflation in a way that overshoots the Fed’s 2% inflation target for some period of time in order to drive unemployment down at a more rapid pace. It was easy enough to say such at the time because the Fed’s preferred inflation gauge, the PCE Index, was running as low as half its 2% target, while the unemployment rate was running 1.5 points above the then-prevailing 6.5% threshold the Fed had provided as a key decision point for its policy.

In the past year—and particularly in the past several months—that picture has changed. The PCE Index has been trending higher and is significantly closer to 2%; meanwhile, the jobless rate has been falling much faster than even the Fed thought it would, ending June at 6.1%. Yellen has since replaced the 6.5% unemployment threshold with a broader basket of quantitative factors more broadly representative of the health of the labor market. In recent speeches and post-FOMC meeting comments, she also has been relatively dismissive of inflation while homing in on the quality and sustainability of improvements in labor market—signals consistent with her optimal control bias favoring keeping the target funds rate lower for longer even at the expense of an overshoot on inflation.

A shrinking consensus?
It’s certain some FOMC members don’t share this view. Philly Fed President Charles Plosser, a voting FOMC member, recently suggested the target funds rate should be hiked in this year’s third quarter, far earlier than the mid-2015 increase implied in the Fed’s own projections. Another voting member, Dallas Fed President Richard Fisher, last week said in a speech at the University of Southern California that the Fed is “overstaying its welcome’’ amid mounting signs of financial market excess and continued economic growth and thus may need to raise the target funds rate by early next year "or potentially sooner." Fisher said he plans to discuss these thoughts at next week’s meeting, which by all accounts promises to be lively even if nothing comes of it.

Certainly, the fixed-income market will be watching closely how this debate will evolve. A policy that is willing to risk higher inflation for the potential for more rapid improvement to a labor market that already is generating nonfarm jobs at the fastest monthly pace in nearly 15 years may prompt some meaningful upward pressure on market yields. That’s not to say yields are poised to spike. International factors have exerted significant downward pressure on Treasury yields in 2014, with geopolitical events prompting flight-to-quality demand for Treasuries, China’s currency policy producing large central bank buying of Treasuries and international investors attracted to U.S. yields that continue to look cheap compared to Japanese and German government bonds. These international factors are not going away too soon. That said, a monetary policy willing to pursue above-target inflation to get unemployment continually lower should insert some greater inflation risk in the nearly “priced-to-perfection” U.S. Treasury market.