Markets welcomed Federal Reserve Chairman Jerome Powell's speech at Jackson Hole on Friday, seeing it as a stirring defense of central bank independence in the face of White House criticism. Indeed, it provided a green light to boost US equity indexes to new records.
That may well have been what the Fed chair intended, but on the surface at least, his speech—which had been in the works for weeks—was simply a reiteration of what he has been saying for months. The economy is on a robust growth path, there is no sign of excessive inflation and the Fed will continue to walk the tightrope of gradual rate hikes, avoiding the twin risks of encouraging inflation with easy money or curbing growth with premature tightening.
Nevertheless, there was a subtext to his remarks, which markets ignored, at least on first reading. This subtext, combined with the minutes of the August meeting released earlier in the week, shows the Fed chairman leaving the door open to skipping a rate hike in December, without appearing to bend to presidential criticism.
Investing.com's Fed Rate Monitor tool, which is based on Fed fund futures prices, is reflecting the growing consensus there may not be a fourth rate hike in 2018. Early last week it was hovering around a 70-percent chance of a quarter-point rate rise in December, before slipping to 67-percent on Friday. It has since fallen further, currently showing a 62-percent chance.
On Friday, Powell said at the outset that his speech would be limited to explaining why the Federal Open Market Committee is on the right track with its normalization process. “As always,” he added, “there are risk factors abroad and at home that, in time, could demand a different policy response, but today I will step back from these.”
This may appear to be a standard disclaimer, however, in light of Wednesday's FOMC minutes from the July meeting and ongoing concerns about the impact of trade disputes on the economy, it could mean Powell simply wanted to avoid a delicate subject at this time. There is, in short, a lot influencing policy that he left out on Friday. It's this subtext that the market overlooked, but it may well be decisive come December.
Powell made a strong case not only that low unemployment no longer necessarily leads to inflation but also that inflation is no longer the best indicator of a tight labor market. He put this in terms of “stars” – u* for the natural rate of unemployment and r* for a neutral interest rate that neither boosts nor curbs the economy.
“In particular, we now know that the level of the unemployment rate relative to our real-time estimate of u* will sometimes be a misleading indicator of the state of the economy or of future inflation,” Powell said. “Second, the reverse also seems to be true: inflation may no longer be the first or best indicator of a tight labor market and rising pressures on resource utilization.”
With the flattening of the Phillips curve, “destabilizing excesses” in the past two recessions showed up first in financial markets rather than in inflation, he said. In other words, the Fed can continue to tighten policy even though inflation shows no sign of breaking out of its target range, while looking elsewhere for warning signs of excess.
A trade war that negatively impacts an economy is another thing altogether, and it's the risk that Powell deliberately excluded from his analysis. The FOMC minutes, however, acknowledged that this kind of disruption could lead the Fed to change policy:
“Some participants suggested that, in the event of a major escalation in trade disputes, the complex nature of trade issues, including the entire range of their effects on output and inflation, presented a challenge in determining the appropriate monetary policy response.”
As well, there is a small but vocal contingent on the panel that does question continued rate hikes in the absence of any evident risk of inflation. St. Louis Fed chief James Bullard, for instance, spoke to journalists on the sidelines at Jackson Hole and reiterated his longstanding belief that the Fed should hold off on further rate increases right now.
Powell noted this diversity of opinion in passing as “one of the great virtues of our system.” Neither Bullard nor Neel Kashkari, head of the Minneapolis Fed and another outspoken dove, are voting members this year in the FOMC’s rotation for regional bank chiefs, but they take part in the debates and fill out the closely watched dot-plot graphs.
Powell’s description of the decoupling of unemployment and inflation cuts both ways. When he concluded in his Jackson Hole speech “we have seen no clear sign of an acceleration above 2 percent” it begs the question of why proceed to another rate hike in December, especially if trade issues are creating all sorts of uncertainties.
The Fed chairman acknowledged that determining the natural rate of unemployment and the neutral interest rate – the rate which neither boosts nor slows economic growth—is an inexact science as economic structures change. Just where the FOMC will come down in December is also difficult to predict.