Looking back to look forward: Jackson Hole preview

Source: Jeff R. Clow via Getty Images.

Fed Chair Jay Powell will deliver his annual remarks this Friday at the Fed’s Jackson Hole Economic Symposium. With the Fed poised to start its rate-cutting cycle next month, any hints on the size and speed of the adjustments will be highly sought. His earlier speeches there, which tell us a considerable amount of how he thinks at a high level about monetary policy, are a good preview.

Go slow unless it’s a crisis.

In his first Jackson Hole as Chair in 2018, Powell spoke on “ Monetary Policy in a Changing Economy” and explained why it’s important for monetary policymakers to be open-minded about how the economy's structure might be changing. He offered the Great Inflation of the 1960s as a cautionary tale when the Fed assumed that the natural rate of unemployment was lower and thus underestimated the inflationary impulse from the labor market. In contrast, in the 1990s, Greenspan correctly argued that the potential output estimates at the time were too low and overstated the inflation risks.

Currently, the focus is on how restrictive monetary policy is—how far is the real federal funds rate above its neutral rate? And is that higher now than before the pandemic? Powell hesitated to offer his estimate of the neutral rate publicly, which would fit with not wanting to create a false degree of precision around a specific estimate. Coming out of the pandemic, there is considerable uncertainty about how the structure of the economy may have changed. The approach that Powell discussed in 2018 remains applicable:

Finally, the literature on structural uncertainty suggests some broader insights. This literature started with the work of William Brainard and the well-known Brainard principle, which recommends that when you are uncertain about the effects of your actions, you should move conservatively. In other words, when unsure of the potency of a medicine, start with a somewhat smaller dose. As Brainard made clear, this is not a universal truth, and recent research highlights two particularly important cases in which doing too little comes with higher costs than doing too much. [Emphasis added.]The first case is when attempting to avoid severely adverse events such as a financial crisis or an extended period with interest rates at the effective lower bound. In such situations, the famous words “We will do whatever it takes” will likely be more effective than “We will take cautious steps toward doing whatever it takes.” The second case is when inflation expectations threaten to become unanchored. If expectations were to begin to drift, the reality or expectation of a weak initial response could exacerbate the problem. I am confident that the FOMC would resolutely “do whatever it takes” should inflation expectations drift materially up or down or should crisis again threaten.

The Fed’s approach to easing starting in September is likely to be conservative, with 25 basis point decreases at each meeting or every other meeting, depending on the inflation data. However, the market gyrations in the first half of August after the disappointing July employment report show how quickly sentiment can turn. With calm restored and no crisis, the Fed’s conservative approach is back on track; however, it would be folly to think this is the last scare. Gradual policy easing over the next few years will also extend the restrictive period of the federal funds rate. Growth scares will continue with some regularity since growth should continue to slow.

Pay attention to the risks.

In 2019, Powell. “Challenges for Monetary Policy” emphasized the role of risks in setting monetary policy:

Because the most important effects of monetary policy are felt with uncertain lags of a year or more, the Committee must attempt to look through what may be passing developments and focus on things that seem likely to affect the outlook over time or that pose a material risk of doing so. Risk management enters our decisionmaking because of both the uncertainty about the effects of recent developments and the uncertainty we face regarding structural aspects of the economy, including the natural rate of unemployment and the neutral rate of interest. It will at times be appropriate for us to tilt policy one way or the other because of prominent risks.

With inflation nearing its 2% target, the Fed’s assessment of risks will likely loom large in its upcoming decisions. In recent weeks, there has been a robust debate about whether the US economy is in or on the verge of a recession. Not being in a recession now is important, but the odds of a recession in the future are critical for monetary policy, which can act with a substantial lag. The Fed is influencing those odds.

Powell’s recounting of the Great Inflation makes clear that ‘over-reacting’ to small increases in the unemployment rate risks a return of inflation and potentially unanchored inflation expectations.

Beginning in the mid-1960s, “stop and go” policy gave way to “too much go and not enough stop”—not enough, that is, to quell rising inflation pressures. Both inflation and inflation expectations ratcheted upward through four expansions until the Fed, under Chairman Paul Volcker, engineered a definitive stop in the early 1980s Each of the expansions in the Great Inflation period ended with monetary policy tightening in response to rising inflation. Policymakers came out of the Great Inflation era with a clear understanding that it was essential to anchor inflation expectations at some low level. But many believed that central bankers would find it difficult to ignore the temptation of short-term employment gains at the cost of higher inflation down the road.

Has the Fed ‘done enough’ to put inflation on its path back down to 2%? If so, any further rise in unemployment comes at a cost with no real benefit. However, that question is impossible to answer with certainty. In leading the easing cycle, Powell must make a strong case that inflation is moving sustainably toward 2% and address any risks of inflation stalling or picking up. The Fed has a dual mandate, but its decisions will continue to be guided by inflation as long as it remains above 2%.

A strong labor market is not a threat on its own.

Of all Powell’s Jackson Hole speeches, the one in 2020, “New Economic Challenges and the Fed’s Monetary Policy Review,” is arguably the least informative for today. It unveiled the Fed’s new strategic framework of flexible average inflation targeting, which was designed to address the challenges of a low-interest-rate, low-inflation environment. Challenges we do not face presently.

That said, the changes to the framework in 2020 with respect to employment might give some insights into the Powell Fed now:

With regard to the employment side of our mandate, our revised statement emphasizes that maximum employment is a broad-based and inclusive goal. This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities. In addition, our revised statement says that our policy decision will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level” as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.

Labor shortages, rapid job switching, and high wage growth earlier in the recovery from the pandemic are largely behind us, and Powell refers to the labor market as being in better balance. According to the framework, a strong labor market now, by the Fed’s assessment, is not necessarily inflationary. However, the Fed is unlikely to identify a shortfall either since the 4.3% unemployment rate is only marginally above the Fed’s median longer-run estimate of 4.2%. There is no reason to expect Powell to call for further weakening in the labor market to bring inflation back to target.

Don’t overreact to temporary inflation.

In “Monetary Policy in the Time of COVID” in 2021, Powell argued that inflation from the pandemic would be “transitory” and that the Fed should keep its rates low. The Fed subsequently began an aggressive hiking cycle as the inflation spread. However, the speech underscores the risks of reacting to short-lived inflation.

The early days of stabilization policy in the 1950s taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation. Indeed, responding may do more harm than good, particularly in an era where policy rates are much closer to the effective lower bound even in good times. The main influence of monetary policy on inflation can come after a lag of a year or more. If a central bank tightens policy in response to factors that turn out to be temporary, the main policy effects are likely to arrive after the need has passed. The ill-timed policy move unnecessarily slows hiring and other economic activity and pushes inflation lower than desired.

… History also teaches, however, that central banks cannot take for granted that inflation due to transitory factors will fade. The 1970s saw two periods in which there were large increases in energy and food prices, raising headline inflation for a time. But when the direct effects on headline inflation eased, core inflation continued to run persistently higher than before. One likely contributing factor was that the public had come to generally expect higher inflation—one reason why we now monitor inflation expectations so carefully. Central banks have always faced the problem of distinguishing transitory inflation spikes from more troublesome developments, and it is sometimes difficult to do so with confidence in real time. At such times, there is no substitute for a careful focus on incoming data and evolving risks.

Debates will rage on whether inflation was “transitory.” The Fed was correct about the temporary nature of inflation, though it underestimated the time horizon. Some argue that transitory implies that it returns to normal without any intervention. The Fed raised rates, which would be an intervention. That’s true, except that the Fed works through demand, and demand held up fine. There are likely a mix of factors, and the retreat of inflation should support a re-calibration of monetary policy, too.

Shelter inflation is currently one area to which the “don’t react to temporary inflation” logic should apply. The increases in tenant and owners’ equivalent rent are the main driver of excess CPI inflation and an important driver of excess PCE inflation. However, the large price shock to new rent contracts was in 2021 and 2022 when a surge in demand and a shortfall in supply collided. Prices on existing rental contracts have risen to reflect that earlier surge in new rents. How long the process will take is uncertain and has lasted longer than initial forecasts. However, the direction is clear and does not justify holding rates high. The risk of ' doing too much ' is rising with inflation down substantially and the federal funds rate elevated.

There will be pain. Or not.

Powell’s message in 2022, “Monetary Policy and Price Stability,” as the Fed was rapidly raising rates, most clearly touches on the current moment. His dire message two years ago turned out to be overly pessimistic:

Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.

Inflation has taken “some time” to come down, but that disinflation has occurred against the backdrop of above-trend growth and two years of historically low unemployment. The economy has slowed relative to the early recovery, but “pain” is not a word to use in describing the past two years. It is a fortunate outcome but one that raises many questions.

So, how did inflation come down, if not via below-normal demand due to higher interest rates? That’s crucial for calibrating policy stance now. This year’s conference is on "Reassessing the Effectiveness and Transmission of Monetary Policy” and should offer relevant research. Powell’s assessment will be critical.

Another part of Powell’s 2022 speech that is relevant now is when to stop:

That brings me to the third lesson, which is that we must keep at it until the job is done. History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting. The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.

There will be no ‘victory lap’ in Jackson Hole, but Powell must explain how the current inflation data and outlook put us sustainably on the path to 2% inflation. Starting to cut rates does not mean that the “job is done,” but rather that we are on the path to it. Powell is leading the Fed through its first major disinflation under an inflation-targeting regime; as much as he likes to refer to the history of monetary policy for lessons, this moment is different in key ways.

Building confidence under uncertainty.

Last year, in “Inflation: Progress and the Path Ahead,” Powell updated us on inflation right after the FOMC raised rates for the last time and several months of disinflation was taking shape.

We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective …

Two percent is and will remain our inflation target. We are committed to achieving and sustaining a stance of monetary policy that is sufficiently restrictive to bring inflation down to that level over time. It is challenging, of course, to know in real time when such a stance has been achieved. There are some challenges that are common to all tightening cycles. For example, real interest rates are now positive and well above mainstream estimates of the neutral policy rate. We see the current stance of policy as restrictive, putting downward pressure on economic activity, hiring, and inflation. But we cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty about the precise level of monetary policy restraint.

That assessment is further complicated by uncertainty about the duration of the lags with which monetary tightening affects economic activity and especially inflation. Since the symposium a year ago, the Committee has raised the policy rate by 300 basis points, including 100 basis points over the past seven months. And we have substantially reduced the size of our securities holdings. The wide range of estimates of these lags suggests that there may be significant further drag in the pipeline.

Beyond these traditional sources of policy uncertainty, the supply and demand dislocations unique to this cycle raise further complications through their effects on inflation and labor market dynamics. For example, so far, job openings have declined substantially without increasing unemployment—a highly welcome but historically unusual result that appears to reflect large excess demand for labor. In addition, there is evidence that inflation has become more responsive to labor market tightness than was the case in recent decades. These changing dynamics may or may not persist, and this uncertainty underscores the need for agile policymaking.

Powell laid out the challenges a year ago and largely the same ones now. It appears that Powell and most Fed officials are growing confident that inflation is moving sustainably toward 2%. However, “more good inflation data” has largely been the extent of the guidance. A framework for assessing progress during the easing cycle that does not hang on each data release would be beneficial.

In closing.

Powell often appeals to the lessons of history for monetary policy, whether it’s from the Great Inflation of the 1960s or the Volcker Disinflation of the 1980s. However, this inflation cycle has defied the playbook in some ways.

There are several principles in Powell’s first six Jackson Hole speeches that are relevant today, and there are many open questions on how his Fed might apply them. Those are the answers you should be listening for on Friday.