We didn’t see anything in Powell’s speech today that meaningfully changes our thinking about Fed policy, but it’s nevertheless a noteworthy talk. Powell continued to develop the themes that have been a focus of his speeches and press conferences throughout the year, elaborating on the role of the Phillips curve in the Fed’s economic outlook—an outlook that, on the surface, may appear too good to be true. Powell again argued that the Phillips curve is intact today and supports the FOMC’s expectation that inflation can remain at (or very near) 2% while the unemployment rate stays below 4%—and well below the median estimate of the NAIRU. The Phillips curve has not died; it has evolved.
It’s worth pointing out that, in discussing the outlook for monetary policy, Powell has focused on the relationship between inflation and unemployment, which is of course critically important. But informing our own expectations for prospective monetary policy decisions, we place considerable importance on the expected sharply slowing growth trajectory over the next couple of years as well. In our view, that slowdown will increase concerns about recession risk and may ultimately cause the Committee to rethink when it stops rate hikes and considers whether an easing will be in order in 2021, if not earlier.
Powell outlined several reasons why the Committee has a forecast that may look “too good to be true”:
1. The slope of the Phillips curve has declined steadily to a very low level today, meaning inflation is relatively insensitive to changes in the unemployment rate. This is widely recognized, but it’s shown clearly in the chart at the end of the paper of the evolution of this parameter over time in rolling regressions. That’s a keeper!
2. Inflation expectations are well anchored, which can be attributed in large part to monetary policy over preceding decades. Well-anchored inflation expectations provide a gravitational pull that would automatically bring inflation back toward 2%, were it to rise above.
3. The degree of inertia in inflation dynamics has sharply diminished, which is shown in another chart by the decline in the coefficient on past inflation in rolling estimates of the Phillips curve. Another keeper! This makes it easier to lower inflation if it moves above 2%.
We usually associate risk management with the optimal response of monetary policy to unusual asymmetric risks, but Powell uses the term in a more general sense. Today he listed key risks to the inflation outlook: 1. Inflation expectations could become unanchored. Sure, but measures of long-term inflation expectations do not show a “material” shift.
2. The hot labor market could begin to push inflation above 2%. But there is no evidence of that. 3. The natural rate of unemployment could be lower than currently estimated. Could be. But that just reinforces the story that this is not too good to be true.
Powell’s comments on the second point are worth noting, as the implications of wage growth have been a recurring theme recently. His take on the wage data hadn’t changed: “These measures have picked up some recently, but in a way that is quite welcome. Specifically, the rise in wages is broadly consistent with observed rates of price inflation and labor productivity growth and therefore does not point to an overheating labor market.”
The Fed’s view on the relationship between wage inflation and price inflation has generally been that the former does not directly cause the latter. Rather, wage inflation is useful in judging the outlook for prices because it provides insight into how tight the economy is. Powell’s first reference to this dynamic, however, pointed to a direct relationship: “Standard economic thinking has long offered an explanation for [why inflation has tended to rise when unemployment has been very low]: If unemployment were to remain this low for this long, employers would be pushing up wages as they compete for scarce workers, and rising labor costs would feed into more-rapid price inflation faced by consumers.” But when he later elaborated on this relationship, he noted that “higher wage growth alone need not be inflationary. The late 1990s episode of low unemployment saw wages rise faster than inflation plus productivity growth without an appreciable rise in inflation”—closer to the standard Fed line we have come to expect. But he didn’t dismiss the first story entirely: “While the late 1990s case proves that elevated values of these tightness measures do not automatically translate into rising inflation, a single episode provides only limited reassurance. Thus, the FOMC takes seriously the possibility that tight markets for labor or other inputs could provide greater upward pressure on inflation than in the baseline outlook.”
All in all, this speech reinforces that Powell does not fit the stereotype of a traditional Republican Fed Chair who is most concerned with limiting the risk of too-high inflation. Powell emphasized that the Committee is carrying out a balancing act, trying to avoid moving too quickly—and needlessly shortening the expansion— and moving too slowly—and risking higher inflation and inflation expectations.