Why the Fed Can’t Talk the U.S. Economy Into Inflation

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.

Circular Logic

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.”