Continued Emphasis on Strong Outlook and Uncertainties

We don’t expect Powell’s prepared remarks for the semiannual testimony to deviate from his June FOMC  press conference, the July FOMC minutes, and, most importantly, his recent interview. The July 2018  Monetary Policy Report, released earlier today, didn’t contain any surprises that would indicate Powell will break new ground in his testimony. 

His current assessment of the U.S. economy is in “a good place from a cyclical standpoint close to our maximum employment and stable prices target. I think the banking system is well-capitalized and much safer,  better managed than it was.” 

The key policy question is whether the FOMC would be comfortable with the unemployment rate being about a percentage point below the NAIRU when the funds rate reaches r-star. It seems that a minority of FOMC  participants are very nervous about that outcome. That outlook leaves the perplexing question of how the  Committee will get the unemployment rate back up to the NAIRU. That would likely end badly, as has usually happened when the FOMC gets behind the curve. 

However, that was not Powell’s response when he was asked about this at the most recent press conference.  He has pretty much dodged this thorny question. He said: maybe they won’t have to get the unemployment rate up, hinting that the NAIRU could be lower than the current median estimate and noting that any overshoot would likely be only a few tenths above 2% because the Phillips curve is so flat. Such a modest overshoot would be clearly within the bounds of the Committee’s symmetric inflation objective. In addition, with inflation expectations arguably below the 2% objective, such a policy would help return inflation expectations to 2%.  It seems unlikely that inflation expectations would become unmoored because of such a modest overshoot,  especially if the FOMC showed it was responding by raising the fund’s rate above its neutral level. But, in any case, the FOMC’s task is to be guided by the incoming data to learn about the NAIRU. 

Powell seems to be quite dovish, much more concerned about recession risk than inflation risk. He sees only modest inflation risk, well within the acceptable range of the symmetric inflation objective. 

On the definition of a “gradual” pace of rate hikes, he will answer three or four hikes a year, as reflected in participants’ rate projections. 

I asked about which conditions would warrant a pause, it would not be too hard to answer: Inflation slowing to below 2%, inflation expectations falling, employment growth slowing sharply, and the economy unexpectedly slowing sharply in the second half. 

Powell diverged slightly from previous FOMC practice in his recent remarks in that he was quite skeptical of point estimates of the NAIRU and the neutral fund’s rate and emphasized the uncertainty around such estimates. He seemed to believe that this uncertainty makes these variables an insufficient guide for making policy. In his view, policymakers should learn about these critical thresholds by scrutinizing the incoming data:  “it’s difficult to forecast the economy and these concepts that we have. It’s not like the fact that water boils  

at 212 degrees. The economy doesn’t boil at 4 percent unemployment. It’s very hard to say these things.” The Committee has clearly been more forecast-driven, as it was in response to the slowdown in inflation. 

The recent shift in Powell’s communication strategy could be described as an intentional emphasis on the inherent uncertainty in economic forecasting and the highly conditional nature of the Fed’s projections: “If it’s coming across as a little bit less certain then I would say it’s working. I don’t want to go all the way to  highly uncertain but I would like to be getting through that economic activity is always subject to great  uncertainty.” We expect his prepared remarks and responses to lawmakers’ questions to reflect this attitude. 

Trade 

Powell and the FOMC likely hold the view that tariffs and retaliation are a threat to the U.S. and global economy and could thwart the FOMC’s efforts to keep the expansion going with inflation near its objective.  But Powell’s responses before Congress will be more diplomatic. He will preface his answer by reiterating that responsibility for trade policy lies with Congress and the White House. As mentioned in the minutes, he  will cite anecdotal evidence from industry contacts of “a rising level of concern about the effects of changes  in trade policy.” He will likely elevate the trade issue by saying higher tariffs are a risk factor and the risk is becoming increasingly large. 

However, Powell has also demonstrated that he is willing to defend the motivation for (if not the execution of) changing the current trading system. In his recent interview, he was sympathetic to the severe effects that changing trade patterns have had on various groups and appreciated the desire for action: “There are always particular groups of people, particular populations and geographies that are negatively affected by trading and the country hasn’t done, no country has really done a good job of addressing those concerns. We  need to do that.” 

As for projections of the consequences of current negotiations, he will likely punt and mention the upside risk from lower tariffs, which in his interview he noted was the stated goal of the Trump Administration, in addition to downside risks from ongoing uncertainty or greater trade restrictions. 

In Powell’s view, the policy levers available to the Fed if a trade war slows the economy are essentially limited to a slower pace of rate hikes or rate cuts. However, he noted that the policy prescription might not be so  clear: “you can imagine situations which would be very challenging, where inflation is going up and the  economy is weakening.” 

What Powell will not do is offer any personal criticism of the White House’s current approach to trade policy:  “When we don’t make the policy, we don’t praise it, we don’t criticize it. We take it as a given.” 

Fiscal Policy 

Powell will handle questions on fiscal policy by distinguishing between its effects in the short term and in the longer term. In the short term, he regards changes in fiscal policy as providing “significant support for, demand  for economic activity probably for at least the next three years.” What’s less certain are the longer-term effects on the supply side. He will conclude his answer with the standard warning about the U.S.’s long-term fiscal sustainability. 

Yield Curve Inversion 

The probability of recession will be a key topic, especially given the prospect that the yield curve will invert,  the Committee expects to move the fund’s rate beyond neutral, and the unemployment rate will be so far below the NAIRU. These suggest a higher recession risk. The yield curve will inevitably come up as a topic.  First, he might say, as some on the Committee do, that it is not clear there will be an inversion as the FOMC  continues to raise rates. Also, he might note that, as reported in the July Minutes, participants generally believe that an inversion of the yield curve today is a less reliable sign of recession. Nevertheless, the FOMC 

will continue monitoring this. He will likely refer to the Fed staff study that strongly dismissed the risk of an imminent recession.1 

The July 2018 Monetary Policy Report did not discuss this topic in-depth but noted that yields have risen and the curve has flattened: “The increase in Treasury yields seems to largely reflect investors’ greater optimism about the domestic growth outlook and firming expectations for the further gradual removal of monetary policy accommodation. Expectations for increases in the supply of Treasury securities following the federal  budget agreement in early February also appear to have contributed to the increase in Treasury yields, while  increased concerns about trade policy both domestically and abroad, political developments in Europe, and  the foreign economic outlook weighed on longer-dated Treasury yields.” 

Fed Transparency and Communications 

Powell will mention in his prepared testimony the decision to have press conferences after each meeting beginning in January as an example of a communications innovation in the direction of greater transparency.  But we don’t expect follow-up questions on this change. 

Monetary Policy Rules 

Lawmakers could bring to attention again a proposal that the Fed chooses a monetary policy rule and explain deviations from that rule. Powell will oppose such proposals, as he would other reforms previously proposed,  including “Audit the Fed.” 

Balance Sheet 

The Fed’s balance sheet is an ongoing point of contention for lawmakers. The biggest question is: How large does the Committee expect the balance sheet to be when it is normalized? Powell and the FOMC are still deliberating on that, so he will refer the audience to the published normalization plans while also emphasizing the uncertainty. The July 2018 Monetary Policy Report discussed the eventual size of the balance sheet in only broad terms: “Although the level of reserve balances that banks will eventually want to hold is not yet known, that level is likely to be much lower than it is today, though appreciably higher than it was before the crisis…If banks want to hold more reserve balances and the public wants to hold more U.S. currency than  before the crisis, the Federal Reserve will need to supply the reserves and currency, so the Federal Reserve’s  securities holdings also will have to be larger than before the financial crisis.” 

As for specific questions about the composition of the balance sheet, questions could be posed about the  future status of the MBS portfolio; Powell again will reiterate the 2014 plan: “in the longer run,” the portfolio  will be “primarily Treasury securities.” 

IOER Policy 

Another controversial issue is IOER payments to banks. Powell will explain that with a floor system, the IOER  rate will be adjusted with the fund’s rate to maintain control over short-term rates and that the IOER payments are more than covered by the income produced by the securities portfolio. From the banks’ perspective, the income from IOER will be offset by higher interest payments as banks compete for deposits. 

Fed Independence 

Powell will stress the importance of central bank independence, especially given the Trump White House’s departure from the longstanding practice of refraining from commenting on monetary policy. The White House  

1 Engstrom, Eric, and Steve Sharpe (2018). “(Don’t Fear) The Yield Curve,” FEDS Notes. Washington: Board of  Governors of the Federal Reserve System, June 28, 2018, https://doi.org/10.17016/2380-7172.2212.

appears to be lobbying for a slow pace of rate hikes, presumably slower than the gradual pace the Committee anticipates. 

However, when asked specifically about recent comments from White House officials, Powell argued that the  FOMC conducts policy in a manner that is “strictly nonpolitical” and said more than once that “nothing has  been said to [him] publicly or privately that gives [him] any concern about [Fed] independence.” 

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