It’s in the Stars

Author: Robert Eisenbeis, Ph.D., Post Date: August 27, 2018

As is the custom for Fed chairs, Chairman Powell provided the kickoff address to the Kansas City Fed’s annual Jackson Hole symposium, broadly attended by many of the world’s central bankers.

For those who are unfamiliar with the conference, the papers presented are generally conceptual economic policy documents with a distinctly longer-run, bigger-picture focus rather than a discussion and assessment of currently policy. In that vein, Chairman Powell provided an interesting and thoughtful discussion of the problems that he and the Fed face in setting policy going forward.

Some commentators on the speech focused on missing elements such as Powell’s failure to mention trade and tariff issues or the changing role that international economic integration has on the policy environment of changing policy regimes. These factors are clearly important but weren’t central to Chairman Powell’s thought piece, which really focused on the more abstract conceptual framework upon which the Fed’s current policy is depends.

Before discussing that framework however, Powell first provided a brief, but obligatory, overview of the current economic situation. It proved to be just a restatement of what was noted in the FOMC’s July/August policy statement and subsequent minutes. He noted that growth is strengthening, unemployment is at a 30-year low, and inflation is at the 2% objective. There was nothing new or noteworthy here.

Then Chairman Powell then turned to the more interesting part of the speech – interesting in part because it appears that he is revealing his own discomfort with the current policy framework. He first poses two disparate questions that observers and critics might ask any FOMC participant today, questions that encapsulate the policy conundrum the FOMC now faces. The questions are paraphrased below:

(1) With unemployment so low, why isn’t the FOMC tightening policy faster to head off potential overheating and a rise in inflation?

(2) Or, with inflation so low, why is the Fed tightening, thereby risking higher unemployment and a recession?

The first question is rooted in a Phillips-curve view of the world in which tight labor markets inevitably lead to inflation, while the second question ignores evidence on the lags of monetary policy and reflects the view that inflation isn’t a problem until it is. Powell has structured these questions as a policy problem of balancing two risks: the risk of being behind the curve versus the risk of being too aggressive.

Against this set of policy questions, Powell then goes on in a clear but oblique way to discuss how economists are currently framing policy in terms of (a) the desired rate of inflation, and (b) the two abstract concepts of the natural rate of unemployment and the natural rate of interest. Economists have dubbed the natural rate of unemployment u-star (u*) and defined it as the rate of unemployment that would prevail in an economy growing at its potential, where people would be unemployed only due to friction and structural reasons – that is, unemployed due to skill mismatches, mobility problems, or lack of information. The natural rate of real interest or r-star (r*) is the real rate that would exist in an economy operating at full employment and growing at its long-run potential.

Powell then proposes the simple, effective analogy that policy is like trying to navigate by the stars (u* and r*), where the course of policy is dictated by inferior instruments (ie. models) in which action depends upon the direction and magnitude of the deviations of actual unemployment from u* and of the estimated real rate of interest from r*. But the problem is that neither of the two stars nor the potential rate of growth of the economy are known with any degree of certainty.[1] Thus it is hard for policy makers to know exactly where the economy currently stands in terms of these conceptual anchors. The problem is doubly difficult because the anchors also have moved over time.[2] It is also important to note at this point in the discussion that Powell omits any mention of the policy tools that the FOMC has in its tool kit or how they are linked to changes in the deviations of the actual economy from u*, r*, or potential growth.

So, if policy makers don’t know exactly where the economy lies relative to these key variables, what are they to do? Put another way, a skeptic would say that the models aren’t working – and this is what Powell is indirectly saying. So, in the face of this conundrum, what does a practical policy maker like Chairman Powell do? His answer is to fall back on risk management, which says go slowly, be observant, and be prepared to act. In the current economic environment of steady growth, low inflation, and low unemployment, this means the FOMC should continue with gradual tightening, since policy is still accommodative, but be prepared to change if inflation and, importantly, inflation expectations change.

Overall, this was a speech that was clear, honest, and pragmatic. Some might have wanted more, especially since stargazing isn’t working too well, but Powell has laid out clearly what the conceptual problems are and how the Fed is proceeding.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio

[1] Indeed, the error bands around estimates of these parameters are quite wide.
[2] As an aside, this is part of the reason that President Bullard of the St Louis Fed has argued that regime shifts make policy formulation and forecasting very difficult.

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