Fed policymakers meet this week at a critical juncture. Growth has slowed in the last few months – no recession, but well below potential, leading to some softening in the labor market. Consumer price inflation has picked up in 2011 and August CPI figures were on the high side of expectations. In their public comments, Fed officials have been divided on the potential benefits and risks of additional policy accommodation. However, some action is expected on Wednesday. The only question is which tool the Fed will pull out of its kit.

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Weekly Commentary by Dr. Scott Brown
Fed Policy Outlook – Something, But What?
September 19 – September 23, 2011
Fed policymakers meet this week at a critical juncture. Growth has slowed in the last few months – no
recession, but well below potential, leading to some softening in the labor market. Consumer price inflation
has picked up in 2011 and August CPI figures were on the high side of expectations. In their public
comments, Fed officials have been divided on the potential benefits and risks of additional policy
accommodation. However, some action is expected on Wednesday. The only question is which tool the Fed
will pull out of its kit.
Recall that the Fed has a dual mandate: price stability and maximum sustainable employment. “Price
stability” does not mean an inflation rate of 0%. Rather, the Fed’s implicit target is 1.5% to 2.0%. The general
belief is that the Fed’s two goals are really one. By keeping inflation low over the long term, economic growth,
and in turn the labor market, will be stronger than it would be otherwise. In normal times, attempts to lower

2. the unemployment rate would lead to inflation pressures, and higher inflation would lead to slower growth
over the long term. However, these aren’t normal times.
The Fed’s aggressive monetary policy has contributed to higher commodity prices, as one might expect, but it
hasn’t been the only cause (increased global demand has been a more important factor and the Arab Spring
boosted global oil prices). Higher commodity prices, if sustained, may be partly passed through to the
consumer and we’ve certainly seen some evidence of this. The apparel component of the CPI, for example,
rose more in the last four months (5.0%) than it did over the previous 23 years. It remains to be seen whether
these price increases will stick. Prices of finished imported goods have risen somewhat over the last year, but
they’re not falling like they were over the previous decade.
The Fed sees inflation as driven largely by inflation expectations, which act as inertia, and the amount of
slack in the economy. Inflation expectations are still low. The Cleveland Fed estimates the 10-year
expectation of inflation at 1.63%. The amount of slack in the labor and product markets remains high. With
unemployment elevated, wage pressures are muted. However, it’s not just labor costs that matter. It’s what
you get for that labor expense. There are difficulties in estimating Unit Labor Costs, which is labor expense
divided by productivity, but recent figures have suggested a possible increase. That doesn’t necessary imply
inflation pressure from labor (as the measure is considered relatively unreliable), but it could mean more
pressure on firms to trim their workforces.

3. For monetary policy, the inflation and unemployment outlooks generate considerable room for debate.
Senior Fed officials have been vocal in their opinions about the appropriate stance of monetary policy and
these officials are divided among the traditional camps, the hawks and the doves. The hawks, fearing
inflation, are some of the district bank presidents, of which only five get to vote on monetary policy at any
time. Some district bank presidents are doves, as are a few of the Fed governors. The moderates will then
have the most sway.
The Fed has been open about the policy tools that were discussed in August and will be debated this week: a
lengthening of the maturity of the Fed’s asset holdings, further asset purchases, and a reduction in the rate
the Fed pays on excess bank reserves. Most likely, we’ll see a maturity lengthening announced on
Wednesday. This is similar to the Operation Twist conducted in the early 1960s. That was considered a
failure, but largely because it was offset by a lengthening of the maturities of securities issued by the
Treasury. The Treasury won’t work against the Fed now.