Jay Powell’s conversion | Financial Times

Good morning. Sometimes the market reaction to Federal Reserve press conferences is fun, and sometimes it is boring. Yesterday, it was boring. Stocks shrugged, as did most of the bond market. The main excitement came in the policy-sensitive two-year yield, which zigzagged for a bit, but even that only finished up 5bp. More on what was actually said below. Email us: [email protected] and [email protected]. 

The Fed

We’ve written several times now that inflation has hit an inflection point and is on the decline. It is nice to know that Fed chair Jay Powell agrees. Here he is at yesterday’s press conference, after the Fed declined to raise rates at this meeting:

With goods we need to see continued healing in supply-side conditions. They’ve improved . . . In terms of housing services inflation, that’s another big piece. And you are seeing there that new rents, new leases are coming in at low levels . . . That leaves the big sector, which is more than half of the core PCE inflation. That’s non-housing services. And we see only the earliest signs of disinflation . . . Many analysts would say the key to getting inflation down there is to have a continuing loosening in labour market conditions, which we have seen . . . I would almost say that the conditions that we need to see in place to get inflation down are coming into place.

All the pieces may be in place, but Powell had the good sense to admit that the rate at which inflation will fall is unknown:

. . . interest sensitive spending is affected quickly [by policy] — housing, durable goods, things like that. But broader demand and spending and asset values take longer. And you can pretty much find research to support whatever answer you would like on that. So there’s not any certainty or agreement in the profession on how long it [disinflation] takes

This admirable piece of realism is, of course, an uneasy fit with the fact that every few months the Fed provides what appear to be fine-grained projections for key economic policies. When you don’t know how fast inflation is going to fall, guessing what the fed funds rate is going to be in six months is hard. This is why the Fed’s policy and its projections are often an odd fit. For example, the median Fed projection for core PCE inflation for year-end 2023 is 3.9 per cent. But if that turns out to be true, the decision not to increase rates yesterday was a mistake. This sort of inconsistency rankles the commentariat.

But it’s better to think of the Fed’s economic projections as a gestalt image, rather than precisely calibrated estimates. So what is the image? The Fed now thinks that, in the near term, growth and inflation will be higher, and unemployment lower, than it thought a few months ago. So policy is going to be tighter for longer, and therefore, in the medium term, growth will be a bit lower. The decision to pause looks odd in the context of this image but, charitably interpreted, it allows for some error in an uncertain moment.

While the Fed is broadly endorsing a tighter policy path, there seems to have been an important shift over the past few meetings. For months, Powell has framed labour market strength as a problem to be solved, because it was the main driver of non-housing services inflation. Yet at the May meeting, he said that “I do not think that wages are the principal driver of inflation”. And yesterday, he emphasised how the “remarkable” performance of the labour market was a support to growth rather than an inflation risk:

The labour market I think has surprised many if not all analysts over the last couple of years with its extraordinary resilience, really. And it’s just remarkable. And that’s really, if you think about it, that’s what’s driving it. It’s job creation, it’s wages moving up, it’s supporting spending, which in turn is supporting hiring and it’s really the engine that is driving the economy.

Highlighting the positive aspects of the tight labour market suggests a Fed that is not monomaniacally focused on increasing unemployment, as some critics allege it is. There’s a plain enough empirical reason for this shift in attitude: in the past year headline inflation has halved while unemployment has stayed very low. The Phillips curve, the classic economics model suggesting a sharp inflation-unemployment trade-off, hasn’t applied recently.

Powell’s conversion to a less stringent view of the Phillips curve appears incomplete, however. Yesterday — in the first quote above — Powell reverted to his old position, saying that the key to bringing down services inflation was “continuing loosening in labour market conditions”.

One questioner, Chris Rugaber of the Associated Press, put his finger on the tension between the old Powell and the new Powell. The response was equivocal:

[Goods-driven inflation in 2021] wasn’t really particularly about the labour market or wages. As you moved into ‘22 and ‘23, many analysts believe that it will be important — an important part of getting inflation down, especially in the nonhousing services sector, to getting wage inflation back to a level that is sustainable . . . We actually have seen wages broadly move down, but just at a quite gradual pace. That’s a little bit of the finding of the Bernanke paper of a few weeks ago

That last line is a reference to the May paper by Ben Bernanke and Olivier Blanchard, which Unhedged has written about. It found that while inflation began with a Covid-19 pandemic shock to goods markets, high wage growth has helped sustain inflation. Bernanke and Blanchard conclude: 

Our decomposition shows that, as of early 2023, tight labour market conditions still accounted for a minority share of excess inflation. But according to our analysis, that share is likely to grow and will not subside on its own. The portion of inflation which traces its origin to overheating of labour markets can only be reversed by policy actions that bring labour demand and supply into better balance.

The takeaway is that the labour market is not the only meaningful target for inflation-fighting policy. If a tight labour market is only a minority contributor to the inflation problem, it suggests we won’t need years of recessionary unemployment levels to get the job done. As Employ America’s Skanda Amarnath put it, “Powell now believes that a resilient labour market is an asset to achieving a soft landing, rather than a hindrance.” This may be overstating Powell’s conversion, but signs of intellectual openness about the workings of inflation can only be good news for investors. It reduces the chance of overtightening.

Of course, Powell has said all along that he hoped inflation could be brought down without a big increase in unemployment (and as such a recession). But old Powell’s beliefs about the role of the labour market in services inflation left little room for this possibility. New Powell’s attitude allows for it. (Armstrong & Wu)

One good read

Branko Milanovic on global inequality.