Fed Policy Outlook: Certainly Uncertain

The minutes of the July 31-August 1 Fed policy meeting and Chairman Powell’s Jackson Hole speech reinforce the view that the central bank will raise short-term interest rates again on September 26. The pace of monetary tightening beyond that is unclear, reflecting a number of uncertainties. The impact of trade wars depends on how long they last and on their severity. However, even without trade disruptions, the Fed faces the same issues it always has when near full employment. There are risks of raising rates too fast, as well as too slow. Powell noted that in the last two recessions, “destabilizing excesses appeared mainly in financial markets, rather than in inflation” and, more recently, the Fed has “greatly expanded the scope of our surveillance for signs of labor market tightness and of destabilizing excesses more generally.”

The Fed’s dual mandate calls for maximum sustainable employment and stable prices. The Fed interprets “price stability” as a 2% inflation rate in the PCE Price Index (call this π*). The natural rate of unemployment (u*) is unclear, and can vary over time (in June, most senior Fed officials put u* at 4.3-4.6%). Under a simple monetary policy rule, such as the Taylor rule, the central bank adjusts policy based on deviations for its objectives (π*, u*). This is more complicated in practice. Powell spoke of the Great Inflation of the 1970s and the tech boom of the late 1990s as illustrating the need for judgement beyond the application of simple rules. In the current environment, there are two opposing Fed policy questions:

1) With the unemployment rate well below estimates of its longer-term normal level, why isn’t the Federal Open Market Committee (FOMC) tightening more sharply to head off overheating and inflation?

2) With no clear sign of an inflation problem, why is the FOMC tightening policy at all, at the risk of choking off job growth and continued expansion?