Fed Chair Powell at Jackson Hole: Defending the Fed’s policies and explaining away inflation

 

*In his speech at the Federal Reserve Bank of Kansas City economic symposium, Fed Chair Powell indicated that the Fed is not yet ready to begin tapering its asset purchases and provided a detailed defense of its current monetary policy.  The speech supported the Fed’s assertion that the sharply higher inflation is temporary, and that inflationary expectations remained well anchored to the Fed’s longer-run objective.  In this regard, parts of the speech seem strained and display an asymmetric assessment of the risks, in our view.

 

*A few highlights:

 

                -While acknowledging improvements in labor markets, Powell stated that the unemployment rate “is still much too high” and the “labor market participation rate has lagged well behind the rest of the labor market”.  Clearly, the Fed is carrying through on its prioritization of maximum inclusive employment established in its new strategic plan, with a very loose interpretation of its tolerance of higher inflation. 

 

                -While Powell acknowledges that inflation has risen sharply and states that “Inflation at these levels is, of course, a cause for concern”, the speech tries to allay those concerns, by:  1) arguing that there is substantial slack in labor markets; 2) identifying temporary price increases of select goods that are expected to fall; and 3) describing carefully selected measures of inflationary expectations that justify the assessment that expectations remain well anchored to 2%.  No doubt Secretary of the Treasury Janet Yellen is nodding in approval.

 

-Powell’s speech makes no reference to the role the Fed’s aggressively easy monetary policy has made in generating the strong recovery in aggregate demand.  Of note, Powell ironically states that “the main influence of monetary policy can come after a lag of a year or more”.  Either the Fed seems to be ignoring its own advice, or this sentence was inadvertently left in the speech from dozens of earlier drafts by Fed staffers.

 

*Markets of course were looking for signals of when the Fed would begin tapering.  Powell did not provide any indication.  But as stated in our preview of the speech, tapering asset purchases is a minor first step toward unwinding the Fed’s emergency monetary policies, and “The far bigger challenge is normalizing interest rates”.  The Fed holds over $5.3 trillion in Treasuries and $2.2 trillion in MBS, and there are trillions of dollars of excess reserves in the banking system, so gradually reducing the magnitude of these purchases while continuing to reinvest maturing assets would have virtually no impact on economic activity. 

 

As expected, Powell emphasized that the timing of the eventual tapering will have no implications for the timing of the interest rate liftoff.  Meanwhile, the Fed estimates the natural interest rate to be 2.5% (2% inflation plus 0.5% real), so delaying liftoff of the Fed funds rate until 2023  maintains monetary accommodation and seems risky.  As Powell states, “Central banks have always faced the problem of distinguishing transitory inflation spikes from more troublesome developments, and it is sometimes difficult to do with confidence in real time”.  The Fed may be expressing too much confidence when in reality there is a lot of uncertainty and risks.

 

Mickey Levy, mickey.levy@berenberg-us.com

 

 



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