The annual meeting at the Jackson Hole, Wyoming, hosted by the Federal Reserve Bank of Kansas City, takes on the most pressing and economic and monetary policies each year.
The key takeaway from Federal Reserve Chairman Jerome Powell's speech on Friday is that, barring a cataclysmic financial or economic event, the Federal Reserve will act slowly and deliberately.
"The Committee's consensus view is that this gradual process of normalization remains appropriate," Powell said in his prepared remarks. "As always, there are risk factors abroad and at home that, in time, could demand a different policy response, but today I will step back from these."
Rather than expect a series of rate hikes that occur sequentially, it is far more likely that they will raise rates one month pause for one or more meetings and then raise again.
Jerome Powell is a fascinating person. He is not an economist by training. Instead, he's an attorney with an impressive private sector history. He's been with the Fed for the latter half of his career primarily working as a technocrat. He's also a very studious person. That characteristic was very evident in his recent speech at the Jackson Hole economic symposium in which he explained the Federal Reserve's basic policy methodology under his leadership.
He began by noting that interest rate policy is guided by several theoretical numbers. The first is the natural rate of unemployment, which is the lowest possible unemployment rate before wage hikes cause inflationary pressure. The second is the natural rate of interest, which is the interest rate that is neither stimulates nor is restrictive of economic activity. The former is referred to as "u star" or u* while the second is called "r star" or r*.
Powell next observed that because these are theoretical numbers, it's possible they can be miscalculated or misunderstood, increasing the possibility the Fed will make a policy mistake. He then analyzes the historical record and highlights one situation where the Fed did make such a mistake and a second where a misunderstanding of these numbers nearly caused a policy mistake.
In the 1970s, the Federal Reserve believed the natural rate of unemployment was very low. This was the reason why they did not raise interest rates as inflation slowly crept higher during the mid-seventies. Because the Fed delayed policy action, inflation rose over 10% but the end of the decade, forcing the new Fed President Paul Volcker to raise rates to astronomically high levels. Hence, a misunderstanding of a theoretical number caused the Fed's delay.
At the end of the 1990s, with the economy running very hot, members of the Federal reserve board argued the bank needed to raise rates to lower potential inflationary pressures. Alan Greenspan argued against this move by arguing that the U.S. economy was in a "new paradigm" where faster growth with lower inflationary pressure was possible. Greenspan won the argument: the Fed delayed raising rates, and the economy expanded for a new year record length of time. Again, a misunderstanding of a theoretical economic number nearly caused a policy mistake.
For Powell, both of these historical situations illustrate that need for Fed policy to be cautious and prudent. He would probably argue that the Fed should have gradually raised rates during the 1970s as a "just in case" policy reaction to then slowly rising process. He would also argue the Fed's "just wait one more meeting" approach of the 1990s was correct. But rather than reacting quickly or extremely, the Fed should almost always pursue a gradual approach to policy. This prevents the Fed from prematurely choking off an economic expansion while at the same time delaying action to such a degree that inflation runs amok. In other words, Powell will follow the Brainard rule for fed policy.
Finally, the literature on structural uncertainty suggests some broader insights. This literature started with the work of William Brainard and the well-known Brainard principle, which recommends that when you are uncertain about the effects of your actions, you should move conservatively. In other words, when unsure of the potency of a medicine, start with a somewhat smaller dose.
The Federal reserve under Powell is more tortoise than hare. Perhaps Powell's steady approach of a technocrat is exactly what the markets need right now.
