Jackson Hole Preview: Everything You Need to Know Before Powell's Big Speech

On Thursday morning, Federal Reserve Chair Jerome Powell will speak at the Kansas City Fed's annual symposium, commonly referred to as the Jackson Hole conference. Powell is expected to discuss the Fed's long-awaited monetary policy framework review. Presumably this review is at (or near) a conclusion and the Chair will be giving us some of the highlights. Since this new framework will chart the course for the Fed in the next several years, this has the makings of a historic speech. We'll be covering what comes out on Real Money Pro on Thursday, but before that here's a preview of what to expect as well as why it matters to investors. Why target higher inflation? We don't know exactly what Powell will say on Thursday. He may go into more or less detail about the framework review conclusions. However, one thing is very clear: The Fed wants average inflation to be higher in future years than it has been in the recent past. This begs one foundational question: Why is more inflation desirable in the first place? Understanding this question is critical to understanding not just this revamped policy framework, but everything the Fed is doing now to restart the economy. Economists believe that real interest rates are what drives economic decisions. The real rate is the stated interest rate minus expected inflation. This is simple to see if you think about it in terms of getting a raise. If you get a 3% raise when inflation is 0%, then you can actually buy 3% more stuff. If you get a 3% raise but inflation is 3%, you really didn't get a raise at all. In that same sense, if the stated interest rate is 3%, it might really be 3% or it might really be 0% depending on inflation. Taking this same logic applied to the Fed's current position, inflation expectations are around 1.5% and the Fed's target is 0%. So, the real rate is -1.5%. If we assume the Fed can't cut the stated rate beyond 0%, the Fed is out of bullets. However, if inflation expectations were really 2% or 2.5%, it would make the current policy stance more stimulative. In central bank parlance, this is called policy space (i.e., the degree of stimulus that the central bank can provide). In the example above, the Fed could engineer another 100 basis worth of stimulus if inflation expectations were 2.5% instead of 1.5%. The Fed also needs to regain credibility In the early 1980s, the public did not believe the Fed could or would control inflation. In order to rebuild that credibility, then Chair Paul Volcker needed to engineer not one but two recessions. Only by continuing the fight against inflation even in the face of rising unemployment did the Fed regain credibility around taming inflation. Today the Fed is trying to do Volcker in reverse. The Fed is going to need to keep rates at zero even in the face of inflation going above their target to prove to the market that they are serious about hitting their 2% target. One reason why this credibility is important is because expectations matter. If everyone expects 2% inflation, and therefore raises prices and wages by 2%, voila! inflation is 2%. Because the Fed has consistently missed their target, expectations have fallen. These low expectations have in and of themselves become a challenge in getting inflation back up. How to target higher inflation? From Volcker until just last year, central bankers were generally much more worried about their inflation-fighting credibility. Their inflation creating credibility wasn't a worry. Now the Fed is challenged to somehow show the world they are willing to allow inflation to rise, but only by a little bit. In other words, create some way of measuring success that shows the Fed will take inflation to run above target for a period without causing inflation expectations to become unmoored. The solution is probably to measure success on inflation over time rather than just on an annual basis. There are two approaches to this that the Fed may be considering. One is average inflation targeting. This is where you pledge to have inflation average 2% over some period of time, say five years. So, if inflation is 1.5% in years 1-2, you have to target 2.3% in years 3-5 such that the average is 2% over the whole period. The other possible approach would be price level targeting. In levels targeting, you would draw a trendline assuming that the overall price level grew at 2% per year, and then you'd target staying on that line over time. Similar to the average inflation targeting above, if actual inflation resulted in the price level falling below the trendline in one year, the Fed would have to allow inflation to run above 2% for some period until we caught up with the level target. Both have merits in their nuances, but ultimately they result in something similar. They are both ways to commit the Fed to allowing inflation to run over target as a catch-up for past misses, while hopefully avoiding inflation expectations from permanently rising above the 2% target. I ultimately think the Fed will embrace one of these two approaches in some fashion. Will this involve new stimulus tools? Even if we assume the Fed decides to target higher inflation for some period of time, it isn't clear how they will achieve this. In other words, if the current set of tools has failed to get 2% inflation for the last 10 years, what makes them think they can get above 2% inflation for any period of time at all? On this front, I expect the Fed will be patient and let rising expectations do the work for them. They have already rejected tools like yield-curve control and negative interest rates. They have also clearly soured on quantitative easing as a tool for directly stimulating the economy. Their QE purchases were aggressive when liquidity was drying up in March, but have since dwindled to nearly nothing. From their actions it is obvious they view QE more as a financial markets tool than a real economy tool. Rather I think the Fed is going to leave rates at zero until the labor market finally gets hot again, and then ignore inflation as it rises through 2% and even higher. When and if that happens, they hope that will reset expectations that inflation will always gravitate toward 2%. Potential for market disappointment is high After the FOMC minutes came out last week, stocks sold off hard over disappointment that there wasn't discussion of fresh stimulus. Again, it is my sense that the Fed doesn't intend to enact any new stimulus at all, but for certain Powell won't hint at anything overt during this speech. That could be setting up markets for disappointment. Even worse would be if Powell were vague about their inflation targeting plans. Some commentators have suggested that the Fed might not formally adopt any sort of average/levels target, or that Powell might just describe some possibilities without going into their specific plans. If that happens, the market will be especially disappointed. Those same minutes made it clear the Fed was punting on forward guidance until this framework review was complete. Then the Chair announces he's giving a speech titled Monetary Policy Framework Review. That has certainly ginned up expectations for this speech. Personally, I think the more explicit the Chair can be in this speech the better, and I think Powell has learned enough about communications not to have promised such a news-making speech without delivering on something. Unfortunately for him, the bar markets have set is very high. Again, I will be putting out a reaction piece here shortly after the speech. Hope to see you back then.

Jackson Hole Preview: Everything You Need to Know Before Powell's Big Speech

Expectations are high for what's likely to be a news-making speech by the Fed Chair. Here's why it matters to investors.

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