Fed Staff Delivers Intellectual Ammo for Hawkish Approach to Inflation
“Because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable, particularly when economic conditions are such that outsized deviations of inflation from its target are a plausible outcome.”
Let’s break the above quote apart and put it in perspective:
- Waiting with rate hikes until inflation materializes is undesirable.
- This is particularly true today after years of global QE and zero-interest-rate policy, when “outsized deviations of inflation” – such as a sudden and hard-to-control surge – “are a plausible outcome.”
The quote is the conclusion of the 39-page research paper by five economists at the Board of Governors of the Federal Reserve, of which Jerome Powell is chairman. The researchers used stochastic simulations to outline how two uncertainties – inflation dynamics and something the Fed calls the natural rate of unemployment (we’ll get to them in a moment) – “affect the choice of strategies for monetary policy.”
The paper was released with careful timing ahead of Powell’s speech at the Jackson Hole symposium, where he defended the Fed’s “gradual” approach to rate hikes against attacks from both sides – those saying they weren’t fast enough, given what’s happening on the inflation front, and those saying that the only good money is cheap money.
The paper wasn’t so balanced. It gave fuel to the discussion at the Fed on how fast to raise rates now that inflation has hit the Fed’s target of 2%, based on the Fed’s preferred measure, core PCE, which has been hovering between 1.9% and 2.0% since May.
The crux is the relationship between the unemployment rate (3.9% in July), a level traditionally associated with effects where labor market tightness leads to rising wages which then pushes up prices. This is the classic model, embodied by the Phillips curve.
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