Hawks Take Centerstage
Abstract: The market seems convinced that the Federal Reserve will lift-off in December, 2015. We argue that this expectation needs to be tempered because the economy begs to differ with the hawks. Fatally for the hawks’ case, the Phillips Curve is broken. And since the neutral rate is now exceptionally low and on a downward trend, the Fed's model risk has increased considerably. The labor market continues to show slack on many indicators including decidedly tepid wage inflation. Moreover, the US economy is not nearly as resistant to an imported deflation as it is to recessionary headwinds from abroad. The baseline scenario continues to be lowflation and stagnation for some time to come. The FOMC is therefore likely to hold fire. And if it does hike in December, it would be running the risk of deflation. A premature exit would harm the recovery that is still underway in the real economy. At the very least, the Fed would be sure to miss its inflation target over the medium term.