Trash Talking the Fed

by | August 1, 2022

In the world of sports, where gaining a competitive edge can mean the difference between winning and losing, ‘trash talking’ is commonplace. Putting your opponent on the defensive, rattling his confidence—those are the aims of trash talking.

One might think that economists wouldn’t stoop to that level. Sure, the profession is competitive, and hyperbole is often rewarded with media attention. But fundamentally, economics is a discipline geared toward understanding and educating, not belittling.

That should be obvious, but it isn’t. Particularly not after last week, when many pundits, including heavyweights Larry Summers and Mohammed El-Erian, skewered Fed Chairman Powell for, in their view, having the audacity to suggest that the Fed Funds rate is now neutral.

So, what’s going on? Should investors and concerned citizens care about economic pettifoggery? Is this just one-upmanship, or is there something genuinely important being debated?

Let’s begin first with the concept of the ‘neutral’ Fed Funds rate. It is commonly understood to be the Fed Funds rate that neither stimulates nor slows economic growth. 

That’s also where agreement ends. Estimates about the neutral Fed Funds rate vary considerably and depend on many factors including whether fiscal policy is expansionary or contractionary, whether the global economy is strong or weak, whether asset prices are soaring or slumping, among others.

The neutral Fed Funds rate is typically considered in real, or inflation-adjusted, terms. Here, too, estimates vary considerably, from as low as 1 percent to as high as 3.5 percent.

One would think that such wide ranges of ‘neutral’ and uncertainties about the factors that influence them would lead to cautious and humble conclusions about what constitutes neutral today. 

But the harshness of the criticism directed at Fed Chair Powell points to something else. Larry Summers said that Powell’s statement was ‘indefensible’. Mohammed El-Erian quipped that neutral is in a different ‘zip code’. Now, it should perhaps be observed that for all his brilliance, Larry Summers is anything but humble. And celebrity economists like El-Erian are not without their controversy. Yet, it is El-Erian’s latest ‘zip code’ comment that was most striking, given that just a few months ago, he admitted in a television interview that ‘nobody knows what the neutral rate is.’

Ok, readers, we get it. We are being just as petty as Powell’s harshest critics. But the point we’d emphasize is that the best opinion on the neutral rate is surely El-Erian’s original take, namely that nobody knows what neutral is. Let’s go a step further and use the Forrest Gump definition: ‘Neutral is what neutral does’.

We’re not being nihilists. There is a key point to be made. If the economy is slowing, even if that weakness is mostly due to factors other than monetary policy, the conclusion is that those restraining factors yield a lower neutral Fed Funds rate. Provided that such restraints—such as falling real wages, collapsing consumer and business sentiment, global economic weakness, and a strong dollar—do not suddenly disappear, then the degree of monetary policy tightening required to neither accelerate nor decelerate the economy (i.e., the neutral Fed Funds rate) will be lower than estimates derived when those restraints are not present.

Of course, it is also true that the presence of inflation, which pushes down the real Fed Funds rate, has the opposite effect, namely high inflation will tend to lift the estimated neutral rate.

But while observed inflation today is indeed high, expectations for future inflation are not terribly elevated. And that is what ought to matter for most borrowing and spending decisions, which is precisely what monetary policy impacts. Presently, for example, five-year inflation expectations derived from US Treasury securities or via surveys range between 2.7-2.9%, which implies a current negative real Fed Funds rate of roughly a half percentage point. 

That may seem stimulatory, but it is worth noting that real Fed Funds rates calculated using expected inflation have been negative more often than positive over the course of the past dozen years without stoking overly strong growth or much inflation. 

Today’s high inflation, in other words, stems largely from non-monetary factors, including adverse supply shocks, one-time fiscal impulses, and pent-up consumer demand unleashed as the pandemic ended. Most of those drivers of inflation are, however, now receding (above all, fiscal stimulus and pent-up demand). Accordingly, we should be cautious about simply concluding that a negative real Federal Funds rate is stoking demand and inflation.

Some observers have suggested that Powell may have misspoken, given that his ‘neutral’ remark was unscripted. Perhaps, but is more likely that Powell was being faithful to the uncertainties surrounding the estimation of neutrality and, more importantly, that he was acknowledging that US economic growth is now decelerating.

And that is what the Fed is supposed to do. Over the past quarter century, various Fed Chairs and their open market committee colleagues have gone to great pains to explain that the Fed is ‘data dependent’. The Fed watches the data and draws inference from it about the appropriate stance of monetary policy consistent with its dual mandate of price stability and maximum employment. By noting that the facts are changing—namely that growth is now decelerating—Powell was speaking just as his predecessors have.

Moreover, Powell has been careful to state that given high inflation, the Fed will probably have to move beyond neutral (i.e., to ‘tight’) during this rate hiking cycle. Accordingly, the allegation that Powell’s comment about ‘neutral’ might be conveyed as ‘mission accomplished’ appears unfounded.

Economics offers, if nothing else, lessons in humility. It is rarely a discipline of precise answers or exact forecasts. Neutral policy rates move around a lot and occupy broad ranges. And that makes quibbling about neutral unhelpful. It is far more important that the Fed—and its critics—focus on the data, and not on scoring points. 

Let’s leave the trash talking to sports.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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