Takeaways From The Fed's Policy Shift at Jackson Hole
Chairman of the Federal Reserve Board, Jerome Powell, is arguably the most powerful person in the world. He is the man we are to believe has control over the global reserve currency, the US dollar. Every year central bankers, politicians, and strategists gather in Jackson Hole, Wyoming for a symposium. 2020 was a special year at the Jackson Hole meeting for a couple reasons.
First, it was livestreamed. Due to the pandemic, speeches were broadcast live over the internet for the first time. Typically, when a speech is recorded from Jackson Hole the speech is not part of the proceedings themselves but from outside on a lawn around the venue. Only later would the transcripts of inside speeches be released. This year, we were able to watch everything.
Second, this year was also the culmination of a two year long internal review by the Fed about the effectiveness of their monetary policy. They announced a new "consensus statement" which outlines how they will interpret their dual mandate from Congress. There was a consensus statement from the Yellen Fed in 2012 but this will only be the second such statement from the Fed.
Different Times, Different Tools
Chairman Powell's remarks started by discussing how the Fed's monetary policy and tools have changed over the years. The Fed's tools, perhaps their whole foundation, were forged in a time of inflation fighting. They came of age in the Great Inflation in the late 1970s, and now, being in a massive debt-driven deflationary environment, the Fed is unable to cope. In our current era, the Fed's actual tools are ineffective which is why they have come to rely mostly on expectation management - i.e. Powell says there is a Biblical flood of money printing though it's a big accounting trick, but people believe him and expect inflation.
"Forty years ago, the biggest problem our economy faced was high and rising inflation. The Great Inflation demanded a clear focus on restoring the credibility of the FOMC’s commitment to price stability. Chair Paul Volcker brought that focus to bear and the “Volcker disinflation,” with the continuing stewardship of Alan Greenspan, led to the stabilization of inflation and inflation expectations in the 1990s at around 2 percent. The monetary policies of the Volcker era laid the foundation for the long period of economic stability known as the Great Moderation. This new era brought new challenges to the conduct of monetary policy. Before the Great Moderation, expansions typically ended in overheating and rising inflation. Since then, prior to the current pandemic-induced downturn, a series of historically long expansions had been more likely to end with episodes of financial instability, prompting essential efforts to substantially increase the strength and resilience of the financial system." (emphasis added)
Fed's Motivations / Failures
Next, Powell speaks about the motivations to undertake this policy review. And wouldn't you know, it's because there has been no real recovery since 2008.
He lists four key economic developments: (1) low and declining growth, (2) a global pressure toward lower rates "not affected" by monetary policy, (3) strong employment, and (4) lack of inflation.
The first step to recovery is admitting you have a problem!
"Our evolving understanding of four key economic developments motivated our review. First, assessments of the potential, or longer-run, growth rate of the economy have declined. For example, since January 2012, the median estimate of potential growth from FOMC participants has fallen from 2.5 percent to 1.8 percent. Some slowing in growth relative to earlier decades was to be expected, reflecting slowing population growth and the aging of the population. More troubling has been the decline in productivity growth, which is the primary driver of improving living standards over time." (emphasis added)
Here Powell admits, despite massive QE, growth estimates continue to fall. He shifts the blame. however, to demographics and productivity. The claim is population and productivity growth are independent variables beyond the scope of the Fed. The reality of the matter is population growth is directly a result of the psychological well-being society derives from the monetary and financial situation in which they find themselves. If society is mired in debt, and the economy is consumption focused, then the time preference of the people will be skewed higher, negatively affecting long-term planning and, finally, population growth. This process happens over time in accordance with the form of money in society. Sound money (gold or bitcoin) leads to more sound demographics, while debt-based money (modern fiat) leads to debt slavery and failing demographics.
Productivity gains, as well, are a result of long-term planning and investment. A dead giveaway that a society is lacking sound investment to improve productivity is an all-consuming focus on the stock market and asset prices. Productivity is not higher stock market prices. Most times, the capital structure (price structure in the economy) must be readjusted in order to create more productivity. When asset prices are "locked-in" then the economy's capital structure is locked-in as well and productivity suffers. So productivity too is a result of time preference influenced by the form of money in society.
Next, Powell admits R-star is not affected by monetary policy.
"Second, the general level of interest rates has fallen both here in the United States and around the world. Estimates of the neutral federal funds rate, which is the rate consistent with the economy operating at full strength and with stable inflation, have fallen substantially, in large part reflecting a fall in the equilibrium real interest rate, or “r-star.” This rate is not affected by monetary policy but instead is driven by fundamental factors in the economy, including demographics and productivity growth—the same factors that drive potential economic growth. The median estimate from FOMC participants of the neutral federal funds rate has fallen by nearly half since early 2012, from 4.25 percent to 2.5 percent." (emphasis added)
Again, the Fed is blaming demographics and productivity growth and treating them as independent variables, which they are not. R-star is falling and the Fed can't do anything about it!
The third key economic development (not quoted for brevity) is the historically strong labor market and low unemployment.
Lastly, the connection the Fed assumed existed between full employment and inflation, guiding monetary policy for decades, never appeared. It doesn't exist. Inflation is not employment and employment is not inflation.
This total failure is accompanied by a shocking admission. When their equations didn't fit, they simply adjusted the variable (U*) to make it balance!!?
"Fourth, the historically strong labor market did not trigger a significant rise in inflation. [...] Inflation forecasts are typically predicated on estimates of the natural rate of unemployment, or “u-star,” and of how much upward pressure on inflation arises when the unemployment rate falls relative to u-star. As the unemployment rate moved lower and inflation remained muted, estimates of u-star were revised down." (emphasis added)
The Fed and Inflation Targets
Now, we get into inflation directly. Powell starts by asserting the premise "low and stable inflation is essential". He continues, if inflation is "too low" for too long, it forms inflation expectations which pull actual inflation still lower. 2% is their magic level. We are to believe, if inflation and inflation expectations are 2% the economy will function properly according to current Fed doctrine.
"After all, low and stable inflation is essential for a well-functioning economy. [...] 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 longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations."
The Fed is admitting inflation expectations are the pivotal factor. Real objective inflation (whatever that is) can be pulled around by expectations. Of course, this is why we see the emphasis on expectation management and it explains the whole shift in their framework.
What the Fed's Policy Shift Entails
Powell outlined their new policy in this paragraph.
"We continue to believe that specifying a numerical goal for employment is unwise, because the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate (***what do they mean by "natural rate?"***) of unemployment over the past decade reinforce this point. In addition, we have not changed our view that a longer-run inflation rate of 2 percent is most consistent with our mandate to promote both maximum employment and price stability. Finally, we continue to believe that monetary policy must be forward looking, taking into account the expectations of households and businesses and the lags in monetary policy’s effect on the economy."
It's a restatement of their mandate of maximum employment and stable prices. For the employment half of the framework, the Fed admits that a "maximum level of employment is not directly measurable" (!). In other words, instead of a symmetric policy for unemployment, meaning the unemployment rate can be too high or too low around a previously precise maximum level, they will intervene only if employment is deemed to be falling short of a "broad-based and inclusive goal" for maximum employment. Needless to say, this is very confusing and arbitrary. We will be watching in the future for any clarification - i.e. how the Fed deals with changes to the labor force participation rate, temporary work, etc.
No dramatic change was made to the inflation target of 2%. However, they later clarified and did subtly change this policy as well, and it was this subtle change that grabbed the most attention from this consensus statement, even though the employment part was a much bigger shift.
What all the fuss is about
Here is the subtle change to the inflation policy.
"We have also made important changes with regard to the price-stability side of our mandate. Our longer-run goal continues to be an inflation rate of 2 percent. Our statement emphasizes that our actions to achieve both sides of our dual mandate will be most effective if longer-term inflation expectations remain well anchored at 2 percent. However, if inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull realized inflation down. To prevent this outcome and the adverse dynamics that could ensue, our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time."
The Fed plans to now consider average inflation of 2% as their target, directly stating they will tolerate a period of inflation above 2% without intervening to cool it off.
What's funny about this change is they completely misidentify the problem. The problem is the Fed has not been able to stimulate inflation. Inflation is stubbornly low despite all their unrestrained QE, and what they thought, was maximum employment. So, how do they intend to overshoot 2%?
The Fed believes they made a mistake by beginning to raise rates when they did in 2016. At the time, they raised rates because employment was at "maximum" and must lead to inflation soon. Therefore, raising rates, which is disinflationary, would balance the inflation from maximum employment at 2%. Why didn't this happen? In their minds they raised rates too soon (this is also why speeches from others at Jackson Hole focused on how rates are now going to stay at zero for the foreseeable future).
We will have to wait and see how much effect this minor change has on the economy. The average inflation target is aimed directly at expectation policy and will have some effect there. By committing to letting inflation overshoot, the Fed will change people's expectations about future Fed policy. Previously, where people would expect policy shifts at or before inflation reaching 2%, now they won't expect policy shifts until maybe 3-4% inflation. It will be a real test of this expectation theory. We feel it is not likely to translate into actual lending and economic activity, because in the dollar growth must come before inflation.
Powell's comments and this new consensus policy statement was not the earth shattering change the financial media made it out to be. We are in the very same position now as before. The Fed is at a loss to create inflation, and are throwing everything behind expectation policy.
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