What Fed Chair Jerome Powell did and did not say
The statement in Jackson Hole by Federal Reserve Chair Jerome Powell on August 27 that the Fed will keep interest rates low in order to focus on "maximum employment" means that the Fed is adapting its medium-term strategy to current economic reality—a welcome step. It also means that the earlier Federal Open Market Committee (FOMC) was wrong to have raised interest rates in 2015-18, particularly to have focused on U* (natural rate of unemployment) rather than labor force participation, and to have tried to set simple policy rules.
But the process of doing the review of the Federal Reserve's monetary policy framework was as important as the results of the review. The trust bought in from Congress and the interested public made political room for current aggressive policies.
The substance of the review was rightly framed as catching the Fed's strategy up to current economic realities—notably, a flat Phillips Curve, lower trend growth rate, very sticky inflation expectations, and a prepandemic rising labor force participation rate. Some of us had asked the Fed to take these realities into account a while ago and to dial back on preempting inflation and to err in favor of going for lower unemployment. See Blanchflower and Posen (2014) for more on underestimating labor market slack. See also Posen and Zettelmeyer (2017) on slowing productivity growth.
Much credit goes to Fed Vice Chair Richard Clarida for starting a process against excessively preemptive policies on inflation right from the start of his term in October 2018, and his taking up this review process to make the changes (along with other FOMC members). See Vice Chair Clarida's first public remarks as vice chair, at PIIE, here.
Great credit also goes to Fed Chair Powell in his first Jackson Hole Economic Policy Symposium speech two years ago, laying the groundwork against setting the course of policy too deeply dependent upon the rules to follow theoretical but not directly observable "stars" (r* and U*).
The short-term impact of this policy shift will be minimal. We saw the 30- and 10-year Treasury interest rates move up a decent amount after Powell's speech by intraday standards, but trivially in macroeconomic terms or compared with the fall rates seen this year.
Powell wisely omitted any mention of forward guidance in his speech. That would have distracted from the main message and would have disappointed. Forward guidance cannot raise inflation when there are real factors pushing it down. When I spoke at the Jackson Hole Economic Policy Symposium back in 2012, I explained why forward guidance is largely useless. At best, it could not hurt, so the next FOMC will probably have something to say about it, but it would be advisable for Fed watchers to ignore it.
Powell's thrust is dovish, but reality based. The fact that interest rates and currencies did not move much is consistent with (albeit does not prove) that the Phillips Curve is flat, that inflation expectations are sticky, and that long-term forward guidance fails.
Another key omission from Powell's speech is that there was no mention of the balance sheet at all. Which is right—it is just another tool, not a source of threat or concern in and of itself, and certainly not a first order strategic concern. In 2009, I spoke about how mechanistic monetarism is misleading.
What about financial stability? There are FOMC members who still believe that low short-term rates increase risks on net. Others, who are inflation hawks, will cover their views by citing financial stability when it is time to call for rate hikes too. With regard to Powell's speech today, the point is that financial stability was not elevated as an ongoing strategic goal, while pushing for maximum employment got upgraded. That wisely reflects the reality that rates are low because of reduced private risk appetite.
Going for maximum employment as opposed to offsetting deviations from FOMC assessments of U* is the biggest dovish shift. We all know that in the past, deviations were treated asymmetrically—too low unemployment was more worried about than too high. Furthermore, going for maximum employment also implies an experimental approach to finding out when labor market tightening shows up in inflation, instead of preemptively trying to guess how low U* is (and usually underestimating labor market slack due to such a narrow focus).
This was a somewhat costly mistake in 2015-18, but also showed up 20 years earlier when Democrat-appointed doves Alan Blinder, Laurence Meyer, and Janet Yellen as members of the Board of Governors argued for raising rates when unemployment got "too low" in the mid-1990s. There are many examples of such errors in other economies.
Robert Solow argued for experimenting to see how low unemployment could go, debating against John Taylor and his eponymous rule, back in 1997, and was in contrast to those FOMC members then.
My former PIIE colleague Angel Ubide made a similar argument in his book The Paradox of Risk in 2017, to be opportunistic in reflation.
Putting it all together, what Chair Powell accomplished in his speech, and in the new Strategic Framework it conveyed, was finally to catch the Fed's strategy up with today's economic realities, and the lessons learned from the last 20 years. As I put it when I was on the Bank of England's Monetary Policy Committee in June 2011, what we are experiencing is "Not That '70s Show." In particular, inflation expectations are incredibly well anchored at low levels and workers have little bargaining power to force wage increases.
Thanks to Chair Powell and the FOMC for letting empirical reality drive the strategic rethink. Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and I wrote Inflation Targeting (1999) in response to specific circumstances, and monetary strategy should adapt to lasting changes in the economic environment. Credit as well to Chair Powell and the FOMC for the transparent and open process by which they made decisions about those strategic choices. That is how they have the political room for the new approach, even though the shift constitutes a move to greater discretion.
As Thomas Laubach and I argued, "Disciplined Discretion" is a successful framework, using flexibility and transparency to get political buy-in. It is a great accomplishment for the Fed, using so many new tools in crisis response that could have been controversial, a year ago directly attacked by the president as a potential enemy, to have earned this much public trust.
Finally, please join Vice Chair Clarida and me on Monday, August 31, at 9 AM ET for a presentation and discussion to further understand the Fed's new strategic framework for monetary policy.