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Fed policy is now in the red zone

Just when you thought there would be no surprises and that the November employment report did not matter because the Federal Reserve was going to hike rates regardless, something unexpected happened. And with this new unexpected event the whole of Fed policy has flipped.

That event is the sharp drop in the unemployment rate to 4.6 percent from 4.9 percent. Until that happened, Federal Open Market Committee members were fighting tooth and nail over whether to hike rates. Now, it may be hard to it to stop raising rates.


The ‘I told you so’ zone

The sharp unemployment-rate drop has taken unemployment to such a low level that it takes all the air out of the Fed's balloon for discretion. The bottom of the Fed's central tendency SEP (summary of economic projections) rate dips to 4.5 percent in 2017 and to as low as 4.4 percent in 2018. But for most members, there is no more room for discretion. The unemployment rate is already lower than most Fed members thought it would ever get to be in a world in which the Fed hit its policy objectives.

Remember how the SEPs are constructed: Each member uses his or her own outlook to pick the path for the federal-funds rate that is optimal for policy to contain inflation. So, for most members, the current level of the unemployment rate already is too low and that means it is inflationary. That is cause for the policy rate (fed-funds rate) to go up faster. This is exactly what the hawks on the FOMC have been warning about. Wait too long and when rates start to go up, they will have to rise quickly in a destabilizing fashion.

The end of waiting

Fed Chair Janet Yellen has told a story of waiting to raise rates and trying to milk the last drops of job growth (unemployment rate slack)out of the economy. But now with this low unemployment rate on the books,Janet's back is to the wall. The hawks will press not just for one hike of a quarter percentage point but for more... soon. We are in the inflation-fighting red zone,where inflation risks are elevated and ever present. The Fed will have to playdefense in this zone much more aggressively to keep inflation out of the end zone.At least that is the premise of the hawks.

This is a problem for the Fedand for Janet Yellen. She has continued to stick to the script of describingeconomic conditions with reference to the unemployment rate. The Fed makespolicy by referencing the actual rate of unemployment and the expected rate ofinflation. And the Fed has been willing from time to time to change the triggerrate used for the unemployment level. But it is now running out of room. The inflation objective is fixed in somesense but because Fed officials project policy today from the inflation rateeach of them sees in the medium term, in reality the inflation rate does notmatter.

The Fed hikes rates today based on its inflation expectations and it judges that from theunemployment rate. Now with the unemployment rate too low on nearly everyone'sscorecard, the solution will be to raise rates higher, sooner faster.

To avoid this, the Fed will could shift to articulate policy in a different way. Maybe it will change the game. But the monetary policyparadigm has been described to us in this way for so long it might be hard forthe Fed to change it. And the hawks will want rates higher regardless.

As things stand, the Fed is out of options. And the hawks are in the driver's seat. TheFed is at the end of its discretionary rope. And while all that is true,weakening job growth is accompanied by weak hours-worked and very little wageinflation. In short, the dogma of the monetarists is fulfilled by the low ratealone.

The unemployment rate is now too low and they are projectingmore inflation. But inflation in fact is not faster, wages in fact are notaccelerating, and there is in fact little evidence that the symptoms thatshould accompany a low unemployment rate (as measured by U3) are in play. Thatonly complicates the story if it is told from a framework other than the labormarket. But the Fed has not been willing to do that. So that leaves theunemployment as the last game in town.

Yellen's back is up against the wall, and it may be thewrong wall, with the hawks in charge.

Commentary by Robert A. Brusca, is chief economist of Fact and Opinion Economics, an economic-consulting firm in New York City. Prior to that, he was chief economist at Nikko Securities and a financial economist and Fed watcher at Irving Trust. Brusca started his career on Wall Street working at the Federal Reserve Bank of NY, where he was chief of the international financial-markets division. He was also the very first guest on CNBC.

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