The Federal Reserve runs a symposium in Jackson Hole, Wyoming, every year. It’s a rite of passage for many in central banking, in monetary economics and for Fed-watching.
Sometimes there is a key Fed policy revelation from the meeting, although not always.
This year, with a lot on the Fed’s plate, it’s very possible that Fed Chairman Jerome Powell on Friday will speak to the star-studded ensemble about the difficult situation facing monetary policy and what the Fed plans to do. If the U.S. wants to be a monetary policy leader, here is a chance to lead.
I have a recommendation for the chairman. It’s really quite simple. There are two extremely obvious things going on that have confused people about Fed policy. They are: 1. How is inflation going to fall as rapidly as the Fed assumes, even before it has raised interest rates only to around the neutral level? 2. How has the Fed picked the level to which it thinks inflation will fall on its own before monetary policy has to do the rest of the work?
Different bandwagon
In 2021, when inflation began to rise, the Federal Reserve first took the position that the rise in inflation was temporary, and therefore the central bank did nothing to counteract it. The Fed is no longer on exactly that bandwagon. But the Fed seems to be on a related bandwagon that sees inflation coming down while it’s raising rates, even though interest rates are well below the rate of inflation. In the past, the Fed had to increase the federal funds rate above the inflation rate to control it. The Fed needs to explain this.
The Fed’s targets
In this framework, the Federal Reserve pulls together forecasts for a number of economic variables and for the federal funds rate. We can look at the central ranges for these forecasts and, within those, see the midpoints. Then we can use that as a rough guide as to what Fed policy sees, and then expects to do.
The Fed currently has these projections for year-end results for 2022, 2023 and 2024. And in these projections, the Fed focuses on the PCE deflator, not the CPI, a gauge for which inflation has gone even crazier than in this PCE.
In June, PCE inflation is up by 6.8% year-over-year while core inflation on the PCE is up by 4.8%. With those, the Fed is looking for the fed funds rate to end 2022 at about 3.35%, 2023 at 3.85% and 2024 at 3.25% Those levels are below the current inflation rate.
The Fed sees headline PCE at 4.4% at end 2022, 2.65% at end 2023 and at 2.25% at end 2024. Using the middle of the central tendency range of Fed member estimates, the metrics give us a real fed funds rate of -1.8% by end 2022, 1.15% by end 2023 and of -0.35% by end 2024. Notably in 2022, with inflation currently at 6.8%, the Fed sees PCE inflation at 4.4% by year-end even though the fed funds rate gets only up to 3.35% by year-end. I think the Fed needs to tell us why that will happen.
Far from attacking inflation with super high interest rates as Paul Volcker did in the late 1970s and early 1980s, this Fed sees inflation breaking lower on its own, with the only task being to push up the fed funds rate to a moderately restrictive level to finish the job.
The public sees a CPI inflation rate that topped 9%, a fed funds rate (currently) at 2.5% and securities markets already buzzing about a Fed “pivot” to dovish conditions. What is that about? On what planet would any sane, experienced securities market investor think that the Fed would stop hiking rates at 2.5% with inflation so high? I cannot answer that. But it seems almost as incredulous to ask why the Fed is only planning to hike the fed funds rate up to 3.85% or 4% as a terminal rate.
Fed credibility is key
The Fed needs to tell us clearly what is happening here. And it has not. That may be because inflation expectations are so low. The University of Michigan inflation expectations reading for five years ahead sees CPI inflation at 4%, according to its mean, and at 3% according to the median.
That may be a sign of confidence in the Fed — or not. The reason I equivocate is that markets may be looking for the Fed to create a recession. The Fed has a lot of explaining to do to convince us one way or the other. It is much more than just having credibility with markets — it must have a workable plan.
But credibility is one of the keys. To have credibility, the Fed has to be willing to face the risks, the potential to fail. And, so far, the Fed mostly feeds us the “have your cake and eat it too” approach as Powell insists there is still a path to a soft landing of the economy.
Increasingly, voices in the markets are wary about the existence of such a path and warn about recession. Will the Fed take this issue head on or not? And will it do it at Jackson Hole or just take a hike?
