Navigating by the Stars

Where is the Fed taking our economy?

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”

By |2018-08-27T05:45:53+00:00August 27th, 2018|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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