Jerome Powell's Jackson Hole Gamble Runs the Risk of Backfiring
It seemed like a good idea at the time.
When Federal Reserve Chairman Jerome Powell rolled out a new modus operandi for running monetary policy at the elite Jackson Hole economic symposium a year ago, the economy was just coming out of a pandemic-driven nosedive. That was after a decade of disappointingly slow growth, with inflation stubbornly below target.
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Powell and his colleagues opted for a radical new strategic framework that Morgan Stanley economist Ellen Zentner says is now embedded in the Fed’s DNA: Use super-loose monetary policy to try to push unemployment down to levels previously thought unsustainable, and commit to letting inflation overshoot their 2% goal by a bit, for a while.
As policy makers prepare for another Jackson Hole conference — the second straight one Powell will address virtually rather than traveling to Wyoming — the economic picture looks much different. Thanks in no small part to a $1.9 trillion, front-loaded budget boost from President Joe Biden that caught Fed officials flatfooted, the economy has roared ahead, with employers complaining they can’t find enough workers. And inflation has taken off, as the unleashing of pent-up demand combined with disruptions to production and shipment schedules to push up the Fed’s favorite price gauge by 4%.
That’s far more than the moderate overshoot that policy makers were seeking. Concerns are now rising that the one-year-old policy blueprint has already passed its sell-by date, and that sticking with it will end up being bad for the health of the economy. The big fear: The Fed will be slow to rein in inflation, paving the way for a sustained take-off in prices, along with a housing bubble that policy makers will eventually have to deal with by jacking up interest rates and derailing the recovery.
“The Fed’s new framework was designed for a world of deficient aggregate demand where supply was not an issue,” says Mohamed El-Erian, the chief economic adviser at Allianz SE and a Bloomberg Opinion columnist. “Coming out of the pandemic, we live in a world of ample demand where the main problem is on the supply side.”
He sees a roughly 40% probability that the Fed will stick with the strictures of the framework too long and ultimately have to slam on the brakes, risking throwing the economy into a recession.
Read more: Moment of Clarida Shapes Jackson Hole Expectations
There’s a lot at stake for Powell — and Biden — in the Fed getting it right. Powell’s four-year reign as central bank chair ends in February. The president has yet to announce whether he’ll nominate the veteran monetary policy maker for another term or choose to replace him, in the middle of the debate over how long to keep ultra-stimulative policy in place. Treasury Secretary Janet Yellen has told senior White House advisers that she supports reappointing Powell, Bloomberg reported Saturday.
Biden is facing increasing flak from Republicans accusing him of igniting the inflation surge by ramming his big aid package through Congress in March. And they’re warning of worse to come if Democrats pass an even more ambitious $3.5 trillion program to extend the government’s reach into the economy.
Powell and administration officials alike have stuck with the line that much of the run-up in inflation will prove to be temporary, as kinks in the supply chain from reopening the $23 trillion American economy are worked out. An eventual increase in the availability in semiconductors, for example, should help automakers feed demand for new cars, bringing down prices.
But the Fed chair has confessed that he’s anxious about the outlook as complaints about rising prices pile up. And he’s hedged his bets in case he’s proven wrong, warning that policy makers would shift course to assure, as he said last month, “we won’t have an extended period of high inflation.” Powell has already initiated formal talks on a path toward pulling back on the central bank’s massive bond buying program, a schedule he may offer more perspective on this week. Most Fed officials last month judged that it likely would be appropriate for the reductions to start this year.
Called “flexible average inflation targeting,” the stratagem Powell unveiled last year turned the Fed’s traditional approach to managing the economy on its head. The central bank’s focus has shifted from trying to contain inflation at 2% to actually fostering it, with the explicit objective of having it run moderately above that pace for a time to make up for years of being below it.
The framework also does away with the Fed’s long-standing tactic of launching pre-emptive strikes against inflation — a strategy that dates back to the late William McChesney Martin, who ruled the Fed from 1951 to 1970 and famously quipped that it was the central bank’s job to “take away the punch bowl just as the party gets going.”
No longer will the Fed raise interest rates to head off higher inflation as the job market tightens. Instead, it will allow unemployment to fall as far as possible, and only seek to slow things down when it’s clear that faster inflation is becoming a problem. In a nod to racial and other inequities plaguing the economy, the Fed also explicitly expanded its definition of what constitutes maximum employment, saying job gains should be broad-based and inclusive.
“The new framework all but guarantees that the Fed will be behind the curve when it starts fighting inflation,” says ex Fed Vice Chairman Alan Blinder. The Princeton University professor sees the Fed starting to lift interest rates from near zero in 2022 — a year earlier than most policy makers had projected in their last set of forecasts in June.
What’s more, the Fed has doubled-downed on its dovish approach by pledging to hold off on changing its policy settings until certain conditions are met, something referred to as forward guidance. It has pledged to keep buying $120 billion of bonds per month — in the process flooding financial markets with liquidity — until “substantial further progress” is made toward its goals of maximum employment and average 2% consumer-price gains. And it’s set out a three-part litmus test for lifting interest rates from zero: achieving full employment and a 2% inflation rate, along with securing an outlook for inflation to moderately exceed 2% for some time.
“The implementation of the framework in this Covid environment has really accentuated the ‘wait until we see the whites of their eyes’ part of the strategy, particularly when it comes to the forward rate guidance,” says Donald Kohn, another former Fed vice chairman, who’s now a Brookings Institution senior fellow. “How the framework is being implemented raises the upside inflation risk.”
Former Treasury Secretary Lawrence Summers sees a new normal with U.S. inflation above 3%. The Fed will then have to decide whether to accept that or attempt to slow down the economy — something which is “rarely a controlled process,” Summers, a paid Bloomberg contributor, says.
Powell initiated the framework review at the start of 2019, well before the pandemic struck. The aim was to avoid the deflationary morass that’s enveloped Japan off and on during the past three decades. When prices overall are falling, consumers tend to hold back on spending and companies put off investing. The result has been a stagnant Japanese economy that has proved resistant to monetary-policy measures — including a promise to seek higher inflation, which presaged the path now being taken by the Fed.
Powell is well aware that the situation the U.S. now finds itself is far different from that envisaged when the framework was hatched. It’s not a world where inflation is quiescent even as unemployment plumbs new lows. Instead, it’s a world where inflation is climbing and unemployment is still well above pre-pandemic levels, posing an acute dilemma for policy makers. Raise interest rates to stem price pressures, and you risk throwing more Americans out of work. Do nothing, and you court the danger of a take-off in inflation akin to what happened in the 1960s and ’70s.
In one sense, Powell and the Fed have had some bad luck, former Bank of England policy maker Adam Posen says. “A policy that was appropriate and still is fundamentally right is being tested by the extreme supply swings from Covid and the very large fiscal stimulus,” Posen, who now heads the Peterson Institute for International Economics, says.
The Fed chief argues that the new strategy is not the policy strait-jacket that El-Erian and other critics say it is, and insists the central bank will act to slow the economy if the burst of inflation threatens to turn into something more long-lasting and pernicious. To back that up, he invokes the letter, if not the spirit, of the operating regime, pointing to a little-commented-on escape hatch in the governing document. In the rare cases when the Fed’s twin goals of maximum employment and stable prices are in conflict — as is the case now — policy makers will weigh the pros and cons of which they should tackle and act accordingly.
But that doesn't give much of a clue on what the Fed will do about the surge in inflation.
“While I am supportive of the new regime, one must recognize that it has both strengths and weaknesses," former Fed Vice Chairman Roger Ferguson says. "It seems to me that it is challenging to decide and communicate how much overshooting is allowable and for how long.”
Rolling back — and eventually eliminating — the stimulus the Fed is pumping into the economy is in one sense the easy part. With unemployment falling rapidly — it dropped to 5.4% in July from 5.9% in June — the Fed is well along in meeting its metric for beginning to taper its asset purchases. In so doing, it will be gradually taking its foot off the accelerator, not stepping on the brake, according to Zentner, Morgan Stanley’s chief U.S. economist.
Powell believes that the real test of the framework will come when the Fed has to decide to raise interest rates — a move that he says is still a long ways off. The crunch would occur if he’s wrong about inflation and it proves more persistent than he expects, forcing the Fed to increase rates before the economy reaches the promised, if somewhat nebulous, land of maximum employment.
The success of the new strategy may ultimately rest with Fed’s ability to convince Americans that it’s got it right when it comes to inflation. If workers and companies think otherwise and are fearful of prices spiraling upwards, they’ll act in ways that will help bring that about. Employees will press for out-sized wage gains, while companies will be quick to jack up prices to cover their rising costs, and then some.
“Bottom line, the critical element is inflation expectations,” former Fed Chairman Ben Bernanke says. “As long as they stay in the vicinity of 2%, the Fed’s strategy will achieve its goals. If inflation expectations were to move significantly higher, the Fed would be forced to tighten more quickly and probably slow the economy more than they would like.”
The evidence on that front so far is mixed, with investors less worried about inflation than consumers seem to be.
Another key question, according to incoming Bank of England policy maker Catherine Mann: Will the wage gains that some workers are now winning and the pricing power that some companies are now enjoying spread more widely throughout the economy? She thinks probably not, as an anticipated slowdown in growth next year helps to check any upward wage-price spiral.
In the end, it will come down to what Powell considers the bigger longer-term risk for the U.S.: Become trapped in a disinflationary spiral like that experienced by Japan as the forces of technological advances and globalization continue to press down on prices, or enter an inflationary zone of escalating cost pressures akin to what the U.S. suffered a half century ago.
Right now, he’s betting that the former is the bigger long-run danger, and holding off from tightening credit.
“The new framework is not so much about what kind of monetary policy you would expect right now, but what you might expect over the next year or perhaps longer as this recovery continues,” Wendy Edelberg, director of The Hamilton Project at the Brookings Institution, says. “They have made a pretty convincing argument they are going to keep monetary policy accommodative for longer than they would have under a different policy rule.”
But the path ahead will be far from easy as the Fed seeks to softly land the economy in the neighborhood of on-target inflation and maximum employment.
“It’s going to very difficult,” says Blinder, who was at the Fed when it achieved what many economists consider its only perfect landing for the economy, in the mid 1990s. “If they can achieve that, they deserve more than a pat on the back.”
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