Monetary policy adrift in an agnostic world

| June 28, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Major turning points are not always obvious in real-time. Chairman Powell’s Jackson Hole speech last August was a pretty big deal, but few could have imagined just how stark of a turning point it signaled at the time. Powell essentially abandoned the Fed staff’s beloved models and shifted the FOMC to a monetary policy regime that might best be described as “winging it.”  With the financial markets and President Trump breathing down the Fed’s neck, the consequences of a policy mistake are unusually high, so now is not a great time for the Fed to be flying by the seat of Chairman Powell’s pants. Yet, that is where the FOMC finds itself, drifting along with little or no framework behind what they are doing.

Traditional Fed framework

 For decades, the Federal Reserve has followed a fairly standard playbook, albeit one that has evolved over time. The ultimate objectives of policy are to fulfill the dual mandate of full employment and price stability, where the Fed has defined price stability as 2% inflation. Fed Board staff models have always had a heavy Phillips Curve flavor, meaning that inflation is thought to be driven primarily by wage pressures.  As Professor John Taylor first laid out in the early 1990s, Fed behavior could be summarized reasonably well by the Taylor Rule, an equation that offers a policy rate prescription based on two gaps: the gap between the unemployment rate and its long-run equilibrium level, which many Fed officials have referred to as “u*”; and the gap between actual inflation and the Fed’s target for inflation.

In broad strokes, the Fed’s policy strategy going back nearly 30 years was to raise and lower interest rates to minimize those two gaps. The zero lower bound presented a whole new set of problems beginning in 2008, but the basic principle remains the same. The Fed spent most of the 1980s and 1990s trying to bring inflation down from the disastrous double-digit highs. Once price stability was more or less achieved, the Fed’s attention turned to preserving its gains on inflation and managing/smoothing the business cycle.

Higher degree of difficulty

 In a convoluted way, the Fed has been a victim of its own success. The Fed’s ability to deliver on its definition of price stability, and, more importantly, to convince the public that it would achieve sustained steady inflation, yielded what central bankers have called “well-anchored” inflation expectations. That is, the public expects inflation to stay near the Fed’s 2% target. With expectations “well-anchored,” inflation tends not to move around very much, as any short-term fluctuations due to shocks such as an oil price spike, are dismissed by the public as transitory and do not set off the sort of wage-price spiral that plagued the economy in the 1970s.

While this is central bank nirvana, well-anchored inflation expectations have changed the playing field for the Fed. In the past, the Fed could take the signals from inflation to guide its efforts to get to appropriate policy. If inflation is above target and rising, tighten. If inflation is below target and falling, ease. In modern times, inflation never moves very much, so the signal is lost.

Similarly, when inflation is fluid, it is fairly easy to tell where the unemployment rate is relative to equilibrium, the other key gap for policy purposes. If the economy is overheating, then wage and price pressures should accelerate, a clear signal that the Fed needs to hike rates, and vice versa. When those wage and price pressures are sensitive to movements in the economy, then it is fairly easy to figure out whether the economy is above or below equilibrium unemployment (u*). In modern times, it can be tougher to know this with confidence. It seems obvious that the unemployment rate has fallen well below u*, as businesses have been complaining for some time about the dearth of qualified workers. However, the absence of a sharp acceleration in wage gains has introduced doubt, and Fed officials have been busily marking down their u* estimates over the past 5+ years.  At the end of 2013, the median FOMC projection for u* was 5.5%, when the actual jobless rate was just below 7%.  This month the FOMC lowered its projection for u* yet again to 4.2%. There are doves on the Committee who continue to insist that a labor market characterized by the lowest unemployment rate in nearly 50 years – and the lowest peacetime unemployment rate in nearly 100 years – still has slack.

The guideposts for monetary policy that the Fed had depended on for decades are no longer generally agreed upon. If inflation never moves by more than a few tenths from the Fed’s target and economists cannot agree on the unemployment gap at any point in time, then how can we know whether policy is appropriate? One answer might be that it doesn’t matter very much. FOMC members in the 1930s or 1970s would have been more than happy to operate in an environment where inflation is low and stable and the unemployment rate is low.

However, the experience of the last 20 years reveals the inadequacy of that answer. The Fed has not had a catastrophic mistake on consumer price inflation since the 1970s, but it has still created plenty of havoc, generating – perhaps only exacerbating – multiple rounds of financial bubbles, including in the 2000s, an episode that ultimately led to the worst economic downturn since the Great Depression. So, the mistakes look different in modern times, but the Fed is still more than capable of creating immense damage.

Jackson Hole fracas

During the Bernanke Fed years, the annual Kansas City Fed Jackson Hole conference took on immense significance, as Bernanke used the occasion several times to send a major signal about monetary policy – for example, hinting at new rounds of QE. The typical pattern during the Bernanke and Yellen years was that the Chair would essentially commission an academic paper from Board staff to support whatever theme they wanted to discuss at Jackson Hole.  The Board staff paper would put an academic stamp of approval on the arguments highlighted in the Chair’s speech.

Something very different happened at Jackson Hole last year. The Board staff paper presented at Jackson Hole was titled “Some Implications of Uncertainty and Misperception for Monetary Policy.”  It addressed many of the issues related to the modern economy detailed above. The traditional academic view had been that when there was uncertainty around the degree of slack in the economy, i.e. the level of “u*”, the Fed was supposed to be more cautious in adjusting policy and was supposed to focus more on the actual behavior of inflation. Indeed, a number of dovish Fed officials had been assertively arguing that the Fed needed to abandon any thought of being pre-emptive and raise rates only when it sees the “whites of the eyes” of inflation, a view that would have been anathema in the 1980s and 1990s.  The Board staff paper noted that this approach is problematic since inflation is less sensitive to variations in slack, or as economists would say, “the Phillips Curve is flat”. The August 2018 Fed Board staff paper found that in the context of simultaneously low inflation and low unemployment, a policy framework that ignores labor market slack and focuses almost exclusively on stabilizing inflation performed poorly. Instead, the paper found that even with a flat Phillips Curve, the Fed should respond to a tight labor market, a conclusion that was quite provocative, as it contradicted the direction in which many FOMC members seemed to be heading.

Chairman Powell’s speech, entitled “Monetary Policy in a Changing Economy,” rather than affirming the Board staff research, body-slammed it. Powell, famously the first non-economist Fed Chairman in decades, essentially took the Board paper and much of the staff’s modeling work, wadded it up, and chucked it into the waste bin. He noted that economists could not accurately ascertain the location of u* or of r*, the equilibrium real rate of interest. He characterized the Fed’s 1960s policy mistake as placing too much faith in its estimate of u*, and the 1990s episode as a success because Chairman Greenspan ignored concerns about a tight labor market and kept policy easier than it otherwise might have been, due to the fact that inflation was not accelerating.

His speech concluded that the Fed basically has to wing it. It can’t raise rates significantly in the face of a tight labor market because it cannot trust estimates of u* enough to ever really know whether the labor market, and in turn the economy, was overheating. At the same time, since inflation does not move much, simply promising to react if and only if inflation gets away from the 2% target was unlikely to work either, since inflation rarely moved much.

One possible interpretation of the speech was that the Powell Fed was going to do what it thought was “right,” without much of an academically rigorous economic framework to fall back on. In contrast to Powell’s assessment of the 1990s, Greenspan’s decision to wing it in the late 1990s arguably contributed to the NASDAQ bubble and the 2001 recession.  The entire FOMC has shifted in recent years from one with a heavy concentration of people with advanced economics degrees to one with a variety of backgrounds. While this could be good since it will allow for a richer array of perspectives, it provokes nervousness that nearly half of the players currently at the FOMC conference table are not economists. That ratio could skew further pending the nomination and confirmation of two individuals for the vacancies on the Board, especially at a time when Powell is trying to pull the Committee away from the economic framework that the Fed has relied upon for decades.

FOMC adrift

This judgmental approach might work out okay, but it is striking to take a step back and think about where the FOMC thought process has moved since Powell’s 2018 Jackson Hole speech. Here are several issues with the way the Fed sees the world:

  • No strong view on u*. FOMC members continue to mark down their estimates of u*, a phenomenon that is not uncommon. Since the NAIRU concept first became popular more than 50 years ago, economists’ estimates of the equilibrium unemployment rate have moved up and down chasing the actual unemployment rate, almost as if u*is simply calculated as a moving average of the actual unemployment rate. What appears to be one of the tightest labor markets in generations has little or no weight in setting monetary policy because Fed officials cannot agree on the degree of slack, do not have a good handle on why wages have failed to accelerate much, and have no idea when and whether wage gains might impact inflation.
  • No idea about inflation. With the Phillips Curve either flat or dead, Fed officials have no idea why inflation does what it does, or what it will do next. This has been especially problematic in 2019, because core inflation dipped early in the year, and policymakers had no idea what to make of the moderation because they have no framework for modelling inflation any more. Officials grew very concerned, but it looks increasingly likely that the softness in the core PCE deflator in early 2019 was a one-off development that should have been downplayed. Chairman Powell and the FOMC started out with that notion, but with little conviction behind their beliefs, several officials were quickly spooked when there were also small movements down in TIPS breakevens (very market directional) and the University of Michigan gauge of consumer inflation expectations (which has been gyrating in recent months).
  • Free-for-all on r*. Historically, assessments of the stance of monetary policy, i.e. whether policy is neutral, accommodative, or restrictive, were derived mainly from some evaluation of the real rate of interest relative to some concept of potential GDP growth. The latter is comparatively simple: potential real GDP growth typically is estimated by the sum of labor supply growth (which is mainly driven by demographics) and trend productivity growth. Since the crisis, Fed officials have broken that linkage, and thus assessments of r* have become almost entirely judgmental. In early 2014, the FOMC pegged potential real GDP growth at 2¼%, while the median longer-run dot was 4%. Add 2% to the real GDP projection to account for inflation, and a view emerges of a reasonably tight link between projected trend nominal GDP growth and the level of “neutral” monetary policy. Today the FOMC’s projection for longer-run real GDP has inched down 30 bp to 1.9%, while estimates of neutrality have plunged by a whopping 150 bp to 2.50%.

Ironically, going back to the economic framework described above, the only thing that has really changed is that productivity growth appears to be in the early stages of accelerating after spending the first half of this decade increasing at little more than ½% per year. In a traditional Fed world, estimates of potential GDP and, in turn, neutral policy would potentially begin to inch up, but with that link broken, Fed officials appear to be working backwards to get to a result for r*.  If the economy appears to be weakening, then “neutral” must be lower than previously thought, even if the source of weakness may be a specific transitory shock, such as uncertainties associated with trade negotiations. It seems the end result of this process is that FOMC estimates of neutrality, like the estimates of u*, are becoming essentially meaningless because they just chase after the current reading of the respective variables  – in the former case, the current fed funds rate target and in the latter case the actual unemployment rate.

  • No anchor for projecting real GDP growth. In the past, Fed officials would generate growth forecasts based in part on their sense of where policy was relative to neutral.  If policy was accommodative, then economic growth could be expected to be above trend and/or accelerating, and if policy was restrictive, then economic growth could be expected to be below trend and/or decelerating. In the brave new world of drifting policy, fluid views of “neutrality” are not much help in projecting the economy’s performance. In fact, it seems to be the reverse: estimates of r* respond to the short-term fluctuations – or even projected fluctuations — in the economy’s growth. The Fed is left to guess about how much “fiscal stimulus” will boost or impede economic activity and how much of an impact the uncertain path of trade negotiations may have. Ironically, in this way of looking at the world, monetary policy is far less important in the growth outlook than it would be if the Fed were still operating within a traditional economic framework.


Perhaps Chairman Powell and the FOMC will exhibit extraordinary wisdom, enjoy a healthy dollop of luck, and use their judgment to consistently calibrate the appropriate stance of monetary policy. Though it is hard to imagine an FOMC that lacks a strong view of whether the economy is running hot or cold, and has no clue how inflation is generated, will get it right all the time. One could fairly argue that the structure of the economy has changed and that the Fed needs to update its models. It’s a given that the models always need to be evaluated with a grain of salt. Ironically, the Fed under Bernanke and Yellen, both career macroeconomists, may have been guilty of relying too much on models. However, it’s nerve-wracking that the Fed appears to have committed itself to flying by the seat of its pants for the foreseeable future.

john.killian@santander.us 1 (646) 776-7714

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