On August 25, the Federal Reserve’s annual conclave kicks off in Jackson Hole, Wyoming. All eyes will be on Fed Chairman Powell’s remarks on Friday, August 26.
Following the recent strong rebound in global equity markets, investors will be keen to hear Powell’s views on the need for higher policy rates, the implications of balance sheet reduction, and the Fed’s outlook for growth and inflation.
Investors crave clarity. Yet, for a variety of reasons, Powell is unlikely to satisfy them. Ambiguity is more likely. Investors hoping Chairman Powell will tell the (Jackson) whole story are likely to be disappointed.
The working title of this year’s Fed confab is ‘Reassessing Constraints on the Economy and Policy’. A reassessment is, by definition, a search for a new starting point and an inauspicious choice for those seeking clarity. Rather, the conference title appropriately alludes to the unknowns confronting the Fed and other central banks as they attempt to guide their national economies toward their policy objectives.
It is by now well known that the Federal Reserve and many economists (including yours truly) mistook last year’s surge in prices for a temporary (‘transitory’) spurt of inflation. And the central banking fraternity and economics profession continue to explore why things have turned out as they have. Debates over the sources and durability of inflation remain unsettled.
But as the working title of the conference hints, part of the answer resides in ‘constraints’ on the economy that have hindered the ability of supply to respond to rising demand.
Those rigidities are visible in still gummed-up global supply chains, compounded by acts of war (Russia’s invasion of Ukraine). They are also found in labor markets, where participation rates remain moribund despite surging nominal wages and plentiful employment opportunities. They can be seen in sluggish responses of global energy supply to the doubling (or more) of crude oil, natural gas, and coal prices. And they can be inferred by listless global business investment spending in the past decade, despite unprecedented declines in equity and debt financing costs and the highest sustained rates of corporate profitability in more than 75 years.
In the past two years, those supply constraints have proven no match for massive shifts in demand owing to the Covid pandemic, the global fiscal policy response, and abrupt changes in household spending patterns. Even a fully flexible supply-side would have struggled to adapt to the enormous Covid slump in demand in early 2020, followed by a surge in goods spending during lockdowns, which was underpinned by the largest peacetime fiscal expansion in history. An inflexible economy had no chance of coping, as today’s supply shortages and soaring prices demonstrate.
Indeed, the past two years have been characterized by shocks to global supply and demand not seen in at least a half century. Arguably they have even been greater than those of the 1970s.
Central bankers and economists have been chastened by these developments. But with error comes, one imagines, humility. Now is hardly the time for the Fed Chairman, or anyone else, to confidently predict what comes next, irrespective of what pundits or investors clamor for.
That doesn’t keep some observers from suggesting where Powell and the Fed should draw the line. This past week, for example, former Goldman Sachs economist and ex-New York Federal Reserve President William Dudley wrote that the Fed must admonish bullish investors who are undermining the Fed’s tightening policy by bidding up asset values.
Dudley’s point, which on the surface appears logical, nevertheless suffers from at least four key misconceptions.
His first mistake is to suggest that today’s high inflation is primarily monetary or financial in origin. As noted, adverse supply shocks and one-time expenditure shocks are arguably much more important.
Dudley’s second misconception is that the cost of capital is important in the sense that rising equity market valuations present a meaningful hindrance to the Fed’s efforts to bring down inflation. That’s wrong. As noted above, for more than a decade, extraordinarily low costs of debt and equity finance failed to unleash an investment boom. Dudley forgets that ‘animal spirits’ (expectations about the future) are more important for making long-lived investment decisions than the current cost of capital. A partial recovery of global equity markets in mid-2022 is unlikely to rekindle business investment spending when, as surveys suggest, CEO confidence is at record lows. Dudley makes an elementary misjudgment of a Keynesian truism that confidence matters more than cost when it comes to making big decisions about the future.
His third error is that portfolio wealth changes have significant impacts on household spending. Ample research suggests they don’t. Moreover, whatever boost to household wealth may arrive via higher share prices will soon be offset by a crumbling housing market. Recall that consumer confidence is also flirting with record lows, hardly a propitious sign for consumption.
Dudley’s final whopper is that the Fed needs to be tough on investors to burnish its credibility. That flies in the face of the evidence. Measures of inflation expectations derived from financial markets show no signs that today’s high inflation is projected to persist. Nor have inflation expectations budged over the past month as investors have bid up share prices.
To be sure, the Fed does face challenges to its authority, but they are found on ‘Main Street’ not ‘Wall Street’. Dudley may overlook them because, like your author, he is the product of decades spent in the worlds of investment banking and investment management. It is difficult to remove yourself from the myopia of finance if that has been your life’s work. But a simple scanning of social media betrays far harsher criticisms of central bankers than anything found on financial pages. Chairman Powell, his Fed colleagues, and central bankers in almost all countries have far more reason to be concerned about populist political backlashes against ‘elitist’ policymaking than they do a genuine mismanagement of inflation in the eyes of professional investors. In that sense, central bankers have to worry about two potential ‘errors’—inflation today and unemployment tomorrow.
In short, Chairman Powell will speak to many audiences on Friday. He will address how the Fed is reassessing constraints on the economy and its policy. Yet those reassessments are underway, not complete. They encompass massive and still not well-understood dislocations to global supply and demand, as well as to the political economy of central banking. That is cause for honest humility, not false bravado.
Powell must, of course, make meaningful observations about the current state of the economy and a broad assessment about the conduct of monetary policy. He almost certainly will recommit to the reduction of US inflation to its target of 2%, but without a specific timetable on how long that may take. He must acknowledge that achieving lower inflation will come at a cost to growth and employment, while emphasizing that those costs will be smaller if accepted today than postponed to the future. In doing so, Powell will also emphasize the need to raise the Fed Funds rate to a restrictive stance over the remainder of this year.
Yet Powell should also take care to acknowledge that some drivers of inflation are already moving in the right direction—for example, falling energy prices or a cooling housing market. He will recognize that global economic weakness—including a probable recession in Europe and a spluttering Chinese economy—will slow US demand and curb domestic inflation pressures.
Indeed, there is much that Chairman Powell can and will say on Friday. But the Fed Chair will be wise to resist clamors from Wall Street for clarity or determination. The Fed’s job and its reputation deserve better than that. It is time for honest ambiguity.
