The Federal Reserve is stuck. On its own, the only way forward is for Chair Jerome Powell to talk a good game.
During a much-anticipated speech delivered virtually for the Kansas City Fed’s annual symposium traditionally held in Jackson Hole, Wyoming, Powell revealed changes to the central bank’s statement on longer-run goals and monetary policy strategy.
The upshot — that the Fed would seek inflation that “averages” 2% over time, therefore allowing overshoots after periods in which it falls short of the target — was well-telegraphed to financial markets. Given the still-murky outlook for economic growth, it suggests interest rates could remain pinned near zero for the next several years.
Traders in longer-dated U.S. Treasuries didn’t seem to know quite how to react to Powell’s speech, with the benchmark 10-year yield initially tumbling to 0.65%, on pace for the biggest drop in weeks, before breaking through a key support level to 0.74%, the highest since June. Thirty-year yields approached 1.5%, up from as low as 1.36%.
Perhaps the confusion stemmed from Powell swinging back and forth on inflation himself.
On the one hand, he emphasized that the central bank would no longer be dictated by a formula that balances employment and price growth, which, as my Bloomberg Opinion colleague Tim Duy eloquently put it, “throws the Taylor Rule into the dumpster.”
That gives policy makers more discretion than before, which could make it more difficult for them to press pause on a hot economy. And yet Powell made clear that any inflation overshoots would only be “moderate,” suggesting there’s some tangible level not too far above 2% that would make the Fed nervous.
The most telling part of all, though, was when Powell tried to explain why he and other central bankers believe that higher inflation is necessary. In effect, it boils down to a circular logic:
“The persistent undershoot of inflation from our 2% longer-run objective is cause for concern.
Many find it counterintuitive that the Fed would want to push inflation up. After all, low and stable inflation is essential for a well-functioning economy. And we are certainly mindful that higher prices for essential items, such as food, gasoline and shelter, add to the burdens faced by many families, especially those struggling with less jobs and incomes.
However, inflation that is persistently too low can pose serious risks to the economy. Inflation that runs below its desired level can lead to an unwelcome fall in long-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.
This dynamic is a problem because expected inflation feeds directly into the general level of interest rates. Well-anchored inflation expectations are critical for giving the Fed the latitude to support employment when necessary without destabilizing inflation. But if inflation expectations fall below our 2% objective, interest rates would decline in tandem.
In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates.
We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome. We want to do what we can to prevent such a dynamic from happening here.”
Powell realizes that the coronavirus crisis has brought the Fed to the end of its rope. Interest rates are near zero, and taking them negative is a nonstarter given that such a policy has arguably only made things worse in Europe and Japan.
The central bank can keep buying Treasuries and mortgage-backed securities, and even purchase corporate bonds and backstop the most strapped state and local governments.
Still, all of this largely serves to support financial markets by making it cheap for large companies to borrow and pushing investors into riskier, higher-yielding assets. The Fed can’t so easily reach the small businesses and service workers most impacted by this economic slowdown.
Trying to Avoid ‘Lower Rates Forever’
Powell wrapped up the Q&A portion by portraying the Fed as fighting tooth and nail to avoid falling into the trap of lower interest rates forever, like the Bank of Japan.
Facing “a reality of a quite difficult macroeconomic context,” he said, “we’ve really got to work to find every scrap of leverage we can get in helping to stabilize the economy, which is our role.”
So he and his colleagues naturally pulled one of the few levers they have left in their more traditional toolkit: talking a big game on inflation.
Notably, the Fed also tweaked the way it views full employment, with Powell conveying that the job market can be at or above estimates of its maximum level without any cause for concern from within the central bank.
This is effectively saying that the unemployment rate, on its own, can never be too low. It all points to the Fed holding short-term interest rates near zero for years to come while creating a much higher hurdle for any policy tightening.
It’s a tired refrain by now, but fiscal policy looks like the only way out of this Japanification of the U.S. Getting cash into the hands of “those struggling with less jobs and incomes,” as Powell put it, will bolster consumer spending, which has long been one of the pillars of the American economy.
That’s the kind of policy that will move money around in the real economy.
Here’s what won’t move the needle: keeping monetary policy so accommodative that cash-rich Apple Inc. can borrow at rock-bottom rates to buy back its own shares, which are already at record highs.
In fact, large companies that keep getting bigger are quite likely contributing to slow wage growth and subdued inflation. But it’s about all the Fed can do at this point.
Powell’s not sure if this change to the Fed’s framework will work: “Time is going to tell,” he said, unhelpfully. For one day, at least, his words managed to lift longer-term bond yields.
Whether all this talk will move the needle in the real economy, on the other hand, is out of the central bank’s control.