Yesterday we heard from US Federal Reserve Chairman, Jerome Powell, as he testified at the House Committee on Financial Services. Obviously the main focus for markets was to glean any additional information regarding the future timing and path of the Fed Funds rate. However, as important for fixed income investors as the future path for rates is, listening carefully to central bankers can also provide insight into the bigger picture economic environment. My ears pricked up in particular at two important and related topics Mr Powell discussed.
First, he was asked about the Fed’s (though one could argue the majority of economists' and market participants') consistent underestimation of NAIRU, the non-accelerating inflation rate of unemployment. Prior to 2018 the Fed’s estimate of US NAIRU was 5.4%, then in early 2018 it was reduced to 4.5% and it now stands at 4.2%, yet the unemployment rate currently stands at 3.7% with no apparent inflation pressure. Powell said the relationship described by the Philips curve (describing a relationship between unemployment and inflation) had consistently lost its predictive power over the last decades. He characterised the current relationship as a "faint heartbeat" whereas 50 years ago it was strong. Instead, his best explanation for inflation’s path was that expectations were anchored at a low level. I agree with his Philips curve comments, but I feel sure that he was using "inflation expectations" as a catch-all for multiple microeconomic factors at work, including in the goods and labour markets. Moreover, while I constantly question the relevance of the economics I was taught over 30 years ago, I refuse to give up on the law of supply and demand, which the Philips curve is ultimately based on.
Why is this important? Well, I am sure that Mr Powell was also taught economics a while ago and has been surprised at how his expected future path of interest rates has changed, even over the last six months. I believe he is secretly shocked that inflation has not responded (yet) to an ever tightening labour market, and he will be concerned at the likelihood that the peak Fed Funds rate will turn out to be 2.5%. He used to talk about ‘normalising’ the Fed Funds rate, and the reason for this was understandably to have ammunition to better deal with the next economic slowdown. In this regard he must feel nervous having much less flexibility than he hoped.
Second, he was asked about the role of fiscal policy, not something in a central banker’s gift, but nonetheless relevant to the overall economic environment. His response was that he would like fiscal policy to be more active or countercyclical, in order to support monetary policy. This is directly related to the point above – that is, the power of monetary policy is diminishing. His comments reminded me of watching European Central Bank President Mario Draghi’s testimonies (see our blog of March 19), when he consistently pleaded for government action to help reinforce monetary policy.
Why am I bringing these thoughts to your attention? The role of fiscal policy has certainly diminished since Keynes' General Theory, as politicians have consistently ballooned fiscal deficits in the pursuit of votes, making countercyclical fiscal policy much more difficult to enact. Over the last few decades this has placed the vast majority of the responsibility for macroeconomic countercyclical policy squarely on the shoulders of central banks.
I think it is likely that Mr Powell, along with other central bankers, despite their public statements are looking at the effectiveness of their toolbox and wondering if the power of traditional monetary policy is approaching the end of the road.