Last Friday, at the Federal Reserve’s (Fed) annual Jackson Hole event, Fed Chairman Powell discussed the challenges the Federal Open Market Committee (FOMC) faces as it continues to normalize interest rates during the current economic expansion in a speech titled “Monetary Policy in a Changing Environment.” Powell highlights the conundrum presented by the Fed’s dual mandate of maximum employment and low, steady inflation.
Currently, the U.S. unemployment rate (µ) is well beneath historical estimates for the natural rate of unemployment (µ*) – the level of unemployment consistent with labor market equilibrium in the economy. The Taylor rule, a representation of a conventional, rules-based approach to monetary policy, would call for the FOMC to raise interest rates when µ < µ* to prevent the economy from overheating and causing destabilizing inflation. However, Powell also contends that the absence of an inflation problem in the current economy warrants looser monetary policy, so as to not choke off the current expansion.
Powell then acknowledges the difficulty in measuring µ* and the potential for error when using the µ to µ* relationship to determine the course for monetary policy. He cites the late ‘60s to early ‘80s as a period when policy makers believed the unemployment rate still had some room to decline before reaching µ*, and that tighter monetary policy would hamper this objective. In hindsight, more relaxed monetary policy likely contributed to the high levels of inflation during this period and allowed the labor market to overheat. Powell then contrasts that period with the mid-1990s, when a Greenspan-led Fed was faced with a booming economy and a µ to µ* relationship that suggested inflation pressures were building. Rather than preemptively hiking rates, however, Greenspan took a “wait and see” approach, with the belief that the economy could handle higher rates of growth than in the past without overheating. Perhaps because he felt µ* had shifted lower, he felt comfortable letting the economy continue to run, with the Fed ready to step in and hike rates should signs of inflation become more evident. Greenspan’s approach worked, and the economy continued to expand without adverse inflationary effects.
Powell concluded his speech by suggesting in the “changing economy” of today, a more conservative approach to monetary policy normalization – especially when removing accommodation of unprecedented levels – is appropriate, so long as inflation does not fall or rise dramatically. He supports a “path of gradually raising interest rates,” giving policyholders time to observe other indicators besides inflation to better assess appropriate levels for today’s µ* and long-term policy rate.
The market’s reaction to Powell’s speech suggests it feels the Fed is less likely to hike rates too quickly and cut the current expansion short. Since last Friday’s speech, the dollar has fallen and global equities have rallied. The dollar has declined over 2% since it hit a high for the year two weeks ago. A market that is pricing in less chance for a Fed policy error should be supportive of equities. Within equities, some of this year’s strong-dollar-themed trades – such as underweight international equities and overweight U.S. small caps – could start to reverse.
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