Last Friday, in his prepared remarks before the Economic Club of New York, Fed Chairman Powell delivered a hawkish message for investors. True, he did not signal imminent rate hikes. Instead, his emphasis was on the need for US monetary policy to remain restrictive for longer.
Investors were surprised by his rhetoric, reflected in markets touching two ‘round numbers’ intraday on Friday—5.0% on the US ten-year Treasury yield and 150.00 for the US dollar against yen. Stocks were also dragged lower.
In his own words, Powell said (bolded for emphasis):
“My colleagues and I are committed to achieving a stance of policy that is sufficiently restrictive to bring inflation sustainably down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. We are attentive to recent data showing the resilience of economic growth and demand for labor. Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.”
Nowhere in his remarks did Chairman Powell suggest that the Fed’s mission to bring down inflation had been accomplished.
To be sure, that would have been more than anyone could have expected. Yet it is worth noting—as even Chairman Powell did—that three- and six-month annualized rates of US inflation have already fallen to levels broadly consistent with the Fed’s 2% inflation target. Similarly, annualized wage inflation over the past six months has decelerated to a rate approaching what many economists believe is consistent with price stability. And other important measures of inflation, such as ‘imputed rents’, are widely expected to fall significantly in the coming months.
So, given most welcome data and recalling that the Fed is a self-described ‘data dependent’ decision-maker, why did Chairman Powell choose to surprise investors with a sterner-than-expected warning?
That question is even more pertinent considering the recent jump in US long-term interest rates. Higher bond yields since mid-year have sent mortgage borrowing rates soaring. Together with wobbly equity markets and a strengthening US dollar, US financial conditions have tightened considerably since July 26, the date of the Fed’s last rate hike.
So how can we explain why Chairman Powell insists on taking away the punchbowl long after its contents have been drained?
In our view, the Fed’s hawkishness can be explained by two factors.
First, the Fed bases its assessment of policy on forecasts for the future and the associated risks to those outlooks. Even if the Fed concludes that the distribution of those risks is symmetrically distributed, that does not mean that it sees the potential errors of getting wrong as equally balanced.
Specifically, when bringing down inflation, the Fed is more willing to accept a recession than a resurgence of inflation. This asymmetry in the Fed’s ‘loss function’, which chiefly stems from its desire (need?) to be seen as credible, means that Chairman Powell feels comfortable with statements such as “keeping policy restrictive until we are confident that inflation is on a path to that objective.”
Observers not saddled with those credibility concerns might point out the inherent risk in such an approach, namely that it could underestimate lags between monetary policy and its impacts on inflation, growth, and unemployment. In other words, by the time the Fed has become sufficiently ‘confident’ that inflation is falling to its target the economy could be irreversibly slipping into recession.
Second, ‘data dependency’ incorporates models, with the Phillips curve model being the Fed’s lodestar. That’s understandable. The idea that inflation springs, in part, from an overheating economy characterized by low unemployment, strong hiring, rising household incomes, and solid wage gains isn’t contentious.
To wit, Chairman Powell noted in Friday’s speech:
“Still, the record suggests that a sustainable return to our 2 percent inflation goal is likely to require a period of below-trend growth and some further softening in labor market conditions.”
“Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.”
Powell’s statements fit neatly inside the Phillips curve framework, one that describes a trade-off between inflation and unemployment.
The only problem is that decades of data only support, at best, a fickle and ever-shifting relationship between inflation and unemployment.
There are many reasons why inflation cannot be solely predicted by how tight the labor market is. If, for example, expectations are for low future inflation outcomes then low rates of unemployment might not produce much acceleration of wage demands that feed into higher prices. That was largely true, for example, in the years immediately before the Covid-19 pandemic when the unemployment rate dipped to a 50-year low of 3.5% and inflation barely budged.
Equally, if worker bargaining power is weak, wage pressures will be subdued. The decline of unions, the advent of globalized labor markets across many industries, and the threat that technology might replace many jobs cowed workers into wage submission over the past quarter century, no matter the unemployment rate.
Macroeconomic shocks can also gum up the Phillips curve relationship. In the 1970s and again during the pandemic some of the biggest blows to the economy came on the supply side. When supplies of foodstuffs, energy, raw materials, and labor shrink, the impact is both higher prices (rising inflation) and falling output, accompanied by rising unemployment. In those circumstances, the Phillips curve utterly breaks down.
So, does that mean the Fed should completely jettison the Phillips curve?
Probably not, and therein lies an important reason why the Fed remains attentive today to potential linkages between tight labor markets and inflation.
Specifically, while attempts to find a stable trade-off between unemployment and inflation over the past half century haven’t worked well, some linkage is visible when unemployment is very low, as is the case today.
For example, looking at data from 1965-2023 and focusing on episodes when the US unemployment rate was at or below 4.5%, the inflation/unemployment trade-off is more apparent. Linear and exponential regressions (results available upon request) suggest a meaningful inverse statistical relationship between them. For instance, linear regression estimates show that when unemployment is already low, inflation will fall by 0.3% for every 0.1% increase in the unemployment rate.
Thus, while it is appropriate to question the use of Phillips curve analysis in all circumstances, it may have merit in those circumstances, like today, when the labor market is already tight. Had investors been equipped with that insight going into Friday’s speech, they might have been less surprised by what Chairman Powell said.
For markets, three further implications ensue:
First, for the Fed to become “confident” (Powell’s words) that inflation is sustainably declining to its 2.0% target, investors must understand that the Fed will remain restrictive so long as the unemployment rate does not rise. That may even be the case when inflation reaches its target. The reason is that low unemployment itself poses the risk of resurgent inflation, something the Fed cannot abide.
Or put more simply, if the labor market does not ease, nor will the Fed.
Second, Federal Reserve policy is not being set with the primary aim of achieving a soft landing. If that outcome is achieved, so much the better. But the parameters that guide the Fed’s decision-making skew the likely outcome toward one of low inflation and rising unemployment.
Third, markets are ill-prepared presently to accept the outcomes that follow. Asset prices still need to adjust. Equity markets, for example, have taken comfort in improving earnings forecasts. Those will have to be revisited if Fed policy stalls the economy.
Bond yields and the US dollar also look toppish. Once below-trend growth, rising unemployment, and price stability occur, investors will pivot to expect Fed easing.
In sum, the Fed is not merely ‘data dependent’. Credibility concerns skew its approach to risk management. Models also matter.
The consequence is that the Fed does not always or even mostly place equal weight on achieving its twin mandates of low inflation and maximum employment. In today’s circumstances, for example, the Fed is far more willing to accept the risk of recession than that of sticky or renewed inflation.