Central bank officials from around the world met at Jackson Hole last week. In this Weekly we highlight the key discussion points and what implications this may have:
(1) The Fed is very committed to bringing inflation down: US Fed Chair Powell in very deliberate, and in his words “more direct” speech, reinforced that his responsibility to deliver price stability is “unconditional” with “a job to do in moderating demand to better align with supply”. There was no mention of a soft landing as Powell had mentioned in earlier speeches, and indeed there may be “some pain to households and businesses”. The Fed’s lesson from the Volcker era is that a failure to restore price stability now, means greater pain later on if the anticipation of high inflation becomes entrenched in economic decision making.
(2) The Fed may keep rates higher for longer to avoid the pre-Volcker mistake: Powell noted that “restoring price stability will take some time” and “will likely require maintaining a restrictive policy stance for some time”. Powell cited the June FOMC SEP projections which had the median funds rate running slightly below 4% through the end of 2023. The Fed’s Kashkari in a subsequent interview elaborated that “ one of the biggest mistakes they made in the 1970s at the Fed is they thought that inflation was on its way down. The economy was weakening. And then they backed off and then inflation flared back up again before they had finally quashed it. We can’t repeat that mistake”.
(3) The Fed “put” is lower than it was previously, given inflation: Equity markets fell in response to Powell’s speech. Historically markets had a rule of thumb that a 10-20% decline in equities would see the Fed pause the hiking cycle, and in some cases start cutting. The put in this cycle is likely considerably lower given inflation pressures. Kashkari noted that he “certainly was not excited to see the stock market rallying after our last FOMC… And I was actually happy to see how Chair Powell’s Jackson hole speech was received. You know, people now understand the seriousness of our commitment to getting inflation back down to 2%”.
a). Central banks unlikely to “run the economy” hot to hit max employment: During the pandemic central banks pivoted to achieving maximum possible employment by delaying rate lift off until inflation was durably at target. Central banks are likely to pivot back to forward-looking policy settings.
b). Central banks may be less willing to look through “temporary” shocks: Given the impact on inflation of what was first deemed to be “transitory” inflation, central banks may take a firmer stance on sizeable supply shocks in the future instead of waiting to see second-round effects as previously.
c). Fiscal policy needs to work with monetary policy to target inflation: A paper by Bianchi and Melosi suggests fiscal credibility is needed so that the government’s financing costs do not impact central bank independence.
Chart 1: Inflation uncertainty is the highest since 1986