The Conversion of Jay Powell

Good morning. Sometimes the market’s reaction to Federal Reserve press conferences is fun and sometimes boring. Yesterday was boring. Equities shrugged, as did most of the bond market. The biggest excitement came from the policy-sensitive two-year rate, which zigzagged a bit, but even rose only 5 bps. More on what was actually said below. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

The Fed

We have now written several times that inflation has reached a turning point and is falling. It’s nice to know that Fed Chairman Jay Powell agrees. Here he is at yesterday’s press conference after the Fed refused to raise rates at this meeting:

With commodities, we need to see lasting healing in supply side conditions. They have improved. . . In terms of inflation for housing services, that’s another big piece. And you see there new rents, new leases coming in at low levels. . . That leaves the major sector, which accounts for more than half of core PCE inflation. Those are non-housing services. And we are only seeing the first signs of disinflation. . . Many analysts would say that the key to getting inflation down there is a continued easing of labor market conditions, which we’ve seen. . . I would almost say that the conditions we need to meet to bring inflation down are being met.

All the puzzle pieces may be in place, but Powell had the good sense to admit that the rate at which inflation will fall is unknown:

. . . interest-sensitive spending is quickly affected (by policy) – housing, durable goods, things like that. But broader demand and spending and asset values ​​take longer. And you can find quite a lot of research to back up any answer you’d like to that. So there is no certainty or agreement in the profession about how long it will take (disinflation).

Of course, this admirable bit of realism doesn’t sit well with the fact that the Fed does every few months offers which appears to be fine-grained projections for major economic policies. If you don’t know how fast inflation will fall, it’s hard to guess what the Fed Funds rate will be six months from now. This is why the Fed’s policy and its projections are often an odd match. For example, the Fed’s median forecast for core PCE inflation for the end of 2023 is 3.9 percent. But if that turns out to be true, yesterday’s decision not to raise rates was a mistake. This kind of inconsistency confuses the commentary.

But it’s better to view the Fed’s economic projections as a gestalt image rather than finely calibrated estimates. What then is the image? The Fed now thinks short-term growth and inflation will be higher and unemployment lower than thought a few months ago. Policy will therefore be tightened for a longer period of time, which means that growth will be somewhat lower in the medium term. The decision to pause looks odd in the context of this image, but interpreted charitably, it allows for an error at an uncertain time.

While the Fed broadly endorses tighter policy, there seems to have been a major shift in the past few meetings. For months, Powell framed labor market strength as a problem to be solved, as it was the main driver of inflation in non-housing services. Still, at the May meeting, he said: “I don’t think wages are the main driver of inflation”. And yesterday he highlighted how the labor market’s “remarkable” performance has been a growth support rather than an inflationary risk:

I think the labor market has surprised many if not all analysts in recent years with its extraordinary resilience. And it’s just remarkable. And that’s really, if you think about it, that’s what drives it. It’s job creation, rising wages, supporting spending, which in turn is supporting hiring and it’s really the engine that drives the economy.

Emphasizing the positive aspects of the tight labor market suggests a Fed that is not monomaniacally focused on raising unemployment, as some critics claim. There is a clear empirical reason for this shift in mindset: headline inflation has halved over the past year, while unemployment has remained very low. The Phillips curve, the classical economic model that suggests a sharp trade-off between inflation and unemployment, has not been applicable lately.

However, Powell’s conversion to a less strict view of the Phillips curve seems incomplete. Yesterday – in the first quote above – Powell reverted to his old stance, saying the key to curbing services inflation was “continued easing of labor market conditions.”

One questioner, Chris Rugaber of the Associated Press, put his finger on the tension between the old Powell and the new Powell. The answer was ambiguous:

(Goods-driven inflation in 2021) wasn’t really about the labor market or wages. As you went into ’22 and ’23, many analysts believed it will be important — an important part of getting inflation down, especially in the non-housing services sector, to bring wage inflation back to a level that is sustainable . . . We’ve actually seen wages fall broadly, but at a fairly gradual pace. That’s kind of the finding of the Bernanke paper from a few weeks ago

That last line is a reference to Ben Bernanke and Olivier Blanchard’s May paper, which Unhedged wrote about. It found that while inflation began with a Covid-19 pandemic shock to commodity markets, high wage growth has helped sustain inflation. Bernanke and Blanchard conclude:

Our analysis shows that as of early 2023, tight labor market conditions continued to account for a minority of excess inflation. But according to our analysis, that share is likely to grow, not decline on its own. The part of inflation that stems from the overheating of labor markets can only be reversed by policies that better balance labor supply and demand.

The conclusion is that the labor market is not the only sensible target for anti-inflation policies. If a tight labor market is only a minority contributor to the inflation problem, it suggests we won’t need years of recessionary unemployment to get the job done. As Employ America’s Skanda Amarnath put it, “Powell now believes that a resilient labor market is an asset to achieving a soft landing, rather than a hindrance.” This may be an overestimation of Powell’s conversion, but signs of intellectual openness about how inflation works can only be good news for investors. It reduces the chance of overtightening.

Of course, Powell has said all along that he hoped inflation could be reduced without a large increase in unemployment (and thus a recession). But old Powell’s views on the role of the labor market in services inflation left little room for this possibility. New Powell’s attitude allows it. (Armstrong and Wu)

A good read

Branko Milanovic op global inequality.