We expect Powell will use his Jackson Hole debut to present the themes that he has emphasized about the conduct of monetary policy while trying not to make any market-moving news. After all, the economy continues to hum along in line with the Committee’s expectations, participants’ rate projections appear likely to remain in place, and there is no uncertainty about the September rate hike. But Turkey and emerging market developments pose uncertainty. That will merit mention, but not the emphasis.
Powell could simply discuss the U.S. outlook and monetary policy and focus on the themes he has been talking about: the implications of uncertainty about the NAIRU and neutral rate for monetary policy; the resulting importance of letting the incoming data inform those estimates; and the role of a flat Phillips curve in lowering the cost of undershooting the NAIRU.
He could also link his remarks about the conduct of monetary policy in the U.S. to the topic of the conference: the implications of changes in market structure for monetary policy. In particular, he could focus on implications of structural changes that have affected inflation dynamics, potential growth, and integration of global capital markets for monetary policy in the U.S.
Changes in Inflation Dynamics
▪ Participants have steadily lowered their estimate of the NAIRU since 2012, by nearly a percentage point in total, which signals their view that structural changes have affected inflation outcomes. Wage growth remains a bit lower than expected, which suggests that there might be changes in the relative market power of firms versus workers. The growth of internet-related sales has implications for pricing and inflation. The conference will discuss the details of these structural changes, but Powell will want to talk about how such changes may have collectively affected inflation dynamics.
▪ Powell has emphasized that these developments raise questions about the reliability of historical regularities, especially those related to inflation dynamics. That means less confidence in Phillips curve predictions and point estimates of the NAIRU. That also implies more emphasis on informing estimates of the NAIRU with incoming data. Today that suggests not overreacting to declines in the unemployment rate below the estimated NAIRU and being more willing to test whether, in fact, the NAIRU might be lower than prevailing estimates. That’s how one can understand how participants project that inflation will remain essentially at 2% even as the unemployment rate falls to, and settles at, 3½%.
▪ Structural changes must be behind the steady decline in participants’ estimated NAIRU. We have linked this trend to persistently lower-than-expected inflation, which pointed to a lower NAIRU. The extent to which inflation surprises are the result of a persistent inflation shock due to globalization and technical change is an open question.
▪ A related structural change is the flattening of the Phillips curve, the reduced sensitivity of inflation to changes in the unemployment rate. That means the cost of undershooting the NAIRU is smaller than otherwise, and the tradeoff between a lower unemployment rate and higher inflation is more favorable— at least for some time. That shifts the focus to avoiding raising rates too fast and too far, a classic recipe for recession.
▪ The emphasis on the asymmetric inflation objective is a way of adapting monetary policy to the uncertainty about inflation dynamics. It is an acknowledgment that the FOMC has less control over inflation and that monetary policymakers live in a world in which inflation will sometimes be above and sometimes below its objective. The message is not to overreact. Committee members have indicated they are comfortable with a temporary and modest overshoot of the inflation objective. As a result, the FOMC shouldn’t respond aggressively to a modest overshoot, which would increase the risk of recession. Lean against it, but modestly as long as inflation expectations remain anchored.
Implications of Slower Growth in Potential Output
▪ A second structural change is the slowing in potential growth, caused in part by demographic developments that have slowed the growth in the labor force.
▪ Potential growth is the most important determinant of equilibrium real rates, including the long-run equilibrium or neutral real funds rate. Monetary policy cannot affect potential output growth or equilibrium real rates, but it can adapt to it.
▪ The buffer between the nominal neutral rate—the sum of the neutral real fund’s rate and the inflation objective—and the zero nominal bound is therefore smaller.
▪ In turn, the amount the FOMC can lower rates in response to an adverse shock will tend to be smaller.
▪ Given that policy, as a result, will more often be constrained by the zero bound when faced by adverse shocks, the FOMC will in such cases have to return to unconventional policies. Central banks around the world are studying ways to make monetary policy more effective at the zero bound.
Globalization and Monetary Policy
▪ The global economy is more interconnected, especially in capital markets. Capital flows move quickly in response to domestic and external developments. Sometimes this creates problems for monetary policymakers, for example, making it more difficult to transmit changes in the short-term policy rate to broader domestic financial conditions. Bad domestic policies can cause the market to lose confidence in a country’s ability to service debt, and a country could find its problems exacerbated by sharp changes in capital flows and declines in their currencies.
▪ Today, Turkey suffers from this problem. The lira is plunging, and there are spillovers to other EMs.
▪ At the same time, EMs today are adjusting to a period of rising rates in the U.S. This direction of U.S. policy should have been anticipated, giving these countries time to adjust. The spillovers from the plunging lira reinforce the adjustment problems of other EMs.
▪ The message is for EM countries to adapt and prepare themselves for such adverse shocks, with more reserves, flexible exchange rates, and sounder banking sectors.
▪ There is little spillover to the U.S., and only substantial spillover to the U.S. would affect U.S. monetary policy.
▪ Still, the disruption of global financial markets can result in asymmetric downside risks to the U.S. and lead to a risk management approach that might call for a delay in rate hikes. But while the current crisis in Turkey and spillovers are serious, the potential consequences are difficult to assess and do not warrant such a risk management approach today. ▪ The global economy is also beset by a trade war that threatens global economic and financial conditions. As Powell has noted many times in his recent public remarks, if the end result is lower tariffs around the world, this will be a favorable outcome. But for now, we have to focus on spillovers to the U.S. These have not become apparent in the incoming data, but here again the FOMC is alert to monitoring spillovers that could affect the strength of U.S. economic activity and inflation.