You’ll Know It When You See It

Powell’s last press conference and recent speech set out a policy strategy going forward that is especially  relevant once the FOMC gets to the estimated neutral rate. When the funds rate is at neutral, the  unemployment rate almost certainly will be under the NAIRU.

Powell focuses less on point estimates of the neutral funds rate and NAIRU and more on how to conduct policy optimally given the very great uncertainty about these two unobservable variables. In addition, he sees the benefits of a low unemployment rate as considerable and the costs as likely to be modest. The implication is to proceed gradually and to test the limits by letting the incoming data inform estimates of the neutral rate and the NAIRU. We call that “you’ll  know it when you see it.” But participants appear to believe the funds rate should rise gradually and directly to their estimate of neutral. In short, it is clear to participants that policy should no longer be accommodative. 

At that estimated neutral rate, however, they should be informed by the data as to whether or not the funds rate is at neutral. That is, they should assess whether growth is slowing toward the trend and the unemployment rate is stabilizing. And, of course, whether or not the unemployment rate is below the NAIRU. We expect the inflation rate will be above 2% at that time. The message here is: Don’t overreact. Be cautious because the  Committee will have to navigate between going too slow, risking higher-than-acceptable inflation, and going too far and precipitating a recession. Powell seems more concerned about the latter. The best outcome is that we find ourselves back in the world of a stable tradeoff. That would be the case if inflation expectations are stable, hopefully at 2%. We’d have inflation a bit above 2% and an unemployment rate a lot below the  NAIRU.  

Question: I wanted to ask how you’re thinking about what to do once you get to neutral. Under what conditions would you decide, once you get there, that it’s okay to stop raising rates? And under what conditions would you want to keep going? 

Powell responds that the question is really “how much longer will you need to be accommodative? And how will you know…at what point policy will be neutral?… We don’t have an exact sense of how that will be…it boils down to a question of, what is appropriate policy?… I think we’ll be very carefully looking at incoming data on inflation, on financial readings, and on the labor market. We have to acknowledge that there are always wide uncertainty bands around the level of, for example, the natural rate of unemployment. But also,  what is the neutral rate of interest? What is that rate of interest that pushes neither up nor down?…we’ll be  guided by incoming data on the economy and try to keep our minds open, as we move forward.” 

He elaborated: “No one really knows with certainty what the level of the natural rate of unemployment is…So we have to be learning as we go. We’ve got to be looking at data and informed by what’s coming in…the fact that we live in that uncertainty is why we’ve been gradually raising rates. We’re not waiting for inflation  to show up.” 

In other words, with respect to the neutral rate, you will know it when you see it. But it is really too late for that strategy. Not that the data won’t matter, but given the data and evolving forecast, most see an urgency to get to neutral and the best they can do is go to the estimated NAIRU. 

Powell Extols the Benefits of A Hot Labor Market 

Given the uncertainty about the NAIRU and the very-flat Phillips curve, it makes sense to test the limits. That is how we have gotten to a “hot” labor market—one where the unemployment rate is very low by historical standards and well below its estimated neutral level. 

“There’s a lot to like about low unemployment….You’ll see people at the, sort of, the margins of the labor force having an opportunity to get back in work. They benefit from that. Society benefits from that.” 

That is reminiscent of the social policy that we attributed to Yellen and especially to the loss function she appeared to have. That loss function was asymmetric with respect to the unemployment rate: A large cost of being above the NAIRU, but little or no cost to being below. Test how low it is by watching the inflation rate. And reap the benefits until then. 

“Our role, though, is also to, you know, to make sure that–that maximum employment happens in a context  of price stability and financial stability, which is why we’re gradually raising rates.”1 

Question: On both inflation and unemployment, the new projections—for unemployment lower than before and inflation higher. And how much is the Fed willing to accept that’s an overshoot for both of those before it affects policy? 

He sidesteps this question, perhaps understandably, because he is being asked about a zone of tolerance.  The Committee should have one, at least implicitly. But the important point is: 

“We won’t overreact to it being over 2 percent. And I think we’ll always be using our tools to move inflation  in the direction of the target, if it—if it leaves—if it moves away from the target persistently, as I mentioned.” 

His strategy requires communicating the implications of a symmetric inflation objective–tying it to monetary policy more explicitly. Those who have talked about an average inflation objective have taken a big step in  

1 Note the difference from most participants, who would have said just maximum employment and price stability. Here, as we have suggested, Powell is more focused on the role of monetary policy with respect to financial stability concerns, though these concerns are not at a point where they affect Powell’s policy choices. 

this direction.2 That shows comfort with being temporarily above 2%. But the Committee must also show a  commitment to the 2% objective by moving the funds rate above the estimated neutral rate 

How Will You Get Back to the NAIRU? 

Question: You guys moved the median unemployment forecast for 2020 down to 3.5 percent but left the longer-run at 4.5 percent today. But you’re only forecasting a moderate overshoot on the Fed funds rate beyond your longer-run value. How are you going to get unemployment from 3.5 percent up to that 4.5  percent rate? 

Powell, in effect, says maybe we won’t have to and, if we do, the data will tell us to do so. 

In a separate speech, Powell noted that the unemployment rate is projected to move to the lowest rate in 40  years. But in his view, “the historical comparison does not shed as much light as we might have hoped.” The  NAIRU is clearly lower, the Phillips curve flatter, and inflation expectations better anchored. This is true. 

And importantly, reflecting this, there is “no sense in our models, or in our projections, or forecasts—that  inflation will take off or move unexpectedly quickly from these levels, even if unemployment does remain  low.” 

“So I would just point you to the range of estimates at the Committee, which I think is 2¼ to 3½, and the median is 2.9, right in there. So that’s the range of estimates of the nominal neutral rate of interest. And we do understand that there’s high uncertainty around the level…How will we know? Well, I think you have to look at inflation.”  

In other words, we’ll know it when we see it! 

Powell makes a very important point that we have also made: A flat Phillips curve makes it very hard to estimate the NAIRU with any precision, adding to their uncertainty. 

I am going to presume Powell will not be entirely backward-looking, data-dependent, but that he will also pay at least some attention to Phillips curve-based inflation forecasts. After all, monetary policy operates with a  lag and most of his colleagues will also pay attention to these forecasts. But, of course, the forecast is based on an estimated NAIRU. Back to the data. 

Question: Have you talked during the meeting about when the Fed is going to remove or change the word accommodative? 

“For a long time, the economy has needed accommodative monetary policy…we will be at a place relatively soon when, again, assuming we stay on this path, when interest rates will be in the zone of what FOMC  participants think is roughly neutral. And, at that point, it would no longer be accurate for us to say that the  

2 Combining this with an inflation-control zone would complete the process. Of course, the key is stabilizing inflation expectations at 2%  (when they rise back to that).

Committee thinks that policy is accommodative. We know that’s coming. We kind of don’t think it’s here  yet, but it’s certainly coming.”  

Again, the emphasis is getting to neutral, at least the zone of neutral, appreciating that the Committee’s decision will reflect the consensus on what the neutral rate is. 

The Two Most Recent Recessions Stemmed Principally from Financial Instability, not High Inflation 

Here we add a critical caveat. In both of these recessions the FOMC got behind the curve--that is, the unemployment rate fell below the NAIRU. The FOMC raised rates aggressively and beyond neutral, fully consistent with the prevailing policy rule. And in each case a recession followed.  

But we also see here the importance Powell places on financial stability concerns, and specifically the response of monetary policy to financial imbalances. Powell is more like Jeremy Stein and less like Bernanke and Yellen.  The latter held the view that monetary policy is a second (indeed last) line of defense and that it might even do as much harm as good. There is a separate tool in this case, macroprudential policy, which allows the  FOMC to focus only on the dual mandate. 

Bottom Line 

Powell, as well as participants more broadly, is most concerned about what to do when the funds rate nears its estimated neutral level and the unemployment rate at that time is way below the estimated NAIRU.  

Powell says to be more cautious and let policy be informed by the data on growth, the unemployment rate,  and, especially, inflation. If growth isn’t slowing to trend, evidenced by a continuing decline in the unemployment rate, then it’s a signal that policy remains accommodative and the funds rate is not yet at neutral. Resume a gradual rise in the funds rate. If the unemployment rate is below the NAIRU at that point,  it will be evidenced by inflation above 2%. But maybe the NAIRU is still lower than the median estimate. But with a flat Phillips curve, even being a percentage point below the NAIRU leads to only a modest increase in inflation.

No runaway inflation. Indeed, as long as inflation expectations remain anchored at 2%, then 2¼%  inflation and 3½% unemployment (for example) could be sustainable, at least for some time. Indeed, in this scenario, the level of long-run inflation expectations is the most important unobserved variable to watch! 

If inflation expectations are stable, we are in the stable-tradeoff world (back to the 60’s). But to keep inflation anchored, we see Powell as saying that the funds rate should rise above neutral to show a commitment to eventually returning to 2%. But not too much above, allowing it to take a few years to get to 2%. 

So the bottom line is not to overreact to inflation above 2%. Wait long enough to assess whether we are in a stable-tradeoff world, which will depend, in turn, on whether inflation expectations are stabilized at 2%.  This is worth testing. The alternative is very bad! 

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