Public Domain. Source: NASA
In a widely-anticipated speech at the Fed’s annual conclave in Jackson Hole, Wyoming, Chairman Jerome Powell discussed how he and the Fed Board of Governors see their role as policy-makers in a dynamic economy. He described the economy as having three natural rates: the natural rate of unemployment, the natural rate of inflation, and the natural rate of interest above inflation: u-star, pi-star, and r-star. These three “stars” remain fairly steady in any particular economy, based on the economy’s structure: its demographics, rate of capital formation, level of innovation, technology, and so on. The stars that guide our Fed are different than the stars in Europe, China, or Japan.
Navigating by the stars may seem simple, but it’s never that easy. Political and economic storms can rock the boat or obscure our view of the economic horizon. And sometimes our best assessment of where the stars should be can change.
Source: Federal Reserve
For the past five years just about every economy has been revising their forecasts for economic growth, unemployment, and interest rates lower. Even though short-term interest rates were at zero, it was understood that inflation should run at 2%, short-term rates would be 2%, and real economic growth would be 2½ %. Now, those values are a lot lower: a 1% r-star, 2% pi-star, and 4.5% u-star.
This has implications for policy today. Unemployment is currently 3.9%. As long as unemployment is well-below its natural rate, the Fed will continue to gradually move short-term rates back to normal, or around 3%. Other factors, like long-term yields or the level of the dollar or political factors simply aren’t as important as the fixed stars in the Fed’s analytical framework.
Navigating with a sextant. Public Domain. Source: NOAA, Wikimedia
Of course, there are precautionary principles that also guide the Fed. For example, when the outlook is foggy, policy-makers should move slowly. Powell compared the Fed to a physician who is uncertain about a medicine’s potency. When you’re unsure, you start with a smaller dose. Still, the direction of policy is clear, at least right now.
We’ve come a long way from when officials at the Federal Reserve considered keeping the markets guessing to be a key part of their job. Alan Greenspan called it “creative obfuscation.” They were concerned that too much transparency would disrupt the markets and the real economy. Now, the Fed is showing us where they want policy to go and how they plan to take it there. As Chairman Powel noted, if strong economic growth continues – and the economy is strong right now – further gradual interest rate increases will likely be appropriate.
In other words, the stars are lining up.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”