Last Friday, Jerome Powell delivered a speech at Jackson Hole that the market clearly interpreted as dovish.
“While inflation has recently moved up near 2 percent, we have seen no clear sign of an acceleration above 2 percent, and there does not seem to be an elevated risk of overheating”, Powell said.
His comments in Wyoming came just hours after the PBoC announced the reinstatement of the counter-cyclical adjustment factor in the yuan fix, capping off a month during which Beijing took a series of steps (see the most recent annotations in the chart below) to arrest the currency’s slide.
(Bloomberg, with my annotations)
That was a rather potent one-two punch for the dollar, which fell, much to the relief of a previously beleaguered emerging markets complex that was beginning to crack under the pressure of a relentlessly stronger greenback and a Fed that appears pigeonholed into hawkishness (lots of birds in there) by the combination of U.S. fiscal and trade policy.
Through Monday, the dollar had fallen in seven of the eight sessions, while the yuan stabilized, giving a boost to EM FX and EM equities, with the latter rising the most since June.
Well, according to Goldman, Powell’s reference to a study by Christopher Erceg, James Hebden, Michael Kiley, David Lopez-Salido, and Robert Tetlow (embedded in full below) means the bond market misconstrued the Fed chair.
I am almost positive that most readers aren’t going to care about the specifics here, but some folks might, so I’m going to try and strike a middle ground by excerpting the executive summary from Goldman’s note and largely glossing over the details from the lengthy Q&A that forms the body of the bank’s analysis.
Describing the study Powell referenced, Goldman notes that the Fed economists mentioned above attempt to “tackle a common objection against the Fed’s ‘balanced approach’ of putting substantial weight on both the deviation of inflation from the 2% target and the deviation of unemployment from the estimated natural rate, u*.”
That objection: the Fed should place less emphasis on low unemployment and more emphasis on inflation. That, the researchers say, would be a mistake.
“The objection is that u* is imperfectly measured and might turn out to be considerably lower than the committee’s current estimate of 4.5% [and] given this uncertainty, the reasoning goes, the Fed should overweight the observed inflation gap, which not only forms half of the mandate but might also provide more information about the amount of slack remaining”, Goldman continues, describing the paper further.
Here’s an excerpt from the research itself:
The standard advice from the literature, that in the presence of mismeasurement of resource slack policymakers should substantially reduce the weight attached to those measures in setting the policy rate, and substitute toward a more forceful response to inflation, is overstated. We find that a notable response to the unemployment gap is typically beneficial, even if that gap is mismeasured. Even when the dynamics of inflation are governed by a 1970s-style Phillips curve, meaningful response to resource utilization is likely to turn out to be worthwhile, particularly in environments where resource utilization is thought to be tight to begin with and inflation is close to its target level.
That’s from the preface, but the overarching point is this, from the conclusion:
Uncertainties about natural rate of unemployment have led many researchers to conclude that policymakers would be well advised to ignore potentially mismeasured labor market slack and focus almost exclusively on stabilizing inflation. This paper has shown that 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.
Obviously, this is exceptionally relevant in the current environment given concerns that the Phillips curve might be prone to reasserting itself in dramatic fashion as it’s wont to do in late-stage expansions. This possibility is magnified by the presence of late-cycle fiscal stimulus and the prospect of tariffs driving up domestic prices on consumer goods.
Goldman reiterates and reinforces the message from the paper as follows:
First, the fact that the Phillips curve is so flat means that backing out current slack from inflation is difficult. Second, the starting point for the economy is one of inflation near the target, unemployment below estimated u*, and growth above trend–a combination that lowers the cost of overestimating u* and raises the cost of underestimating u*. Taken together, these points suggest that the Fed should put at least as much weight on the estimated employment gap as in the “balanced approach” under current circumstances.
Again, the implication is that Powell’s mention of that paper suggests he’ll be inclined to put at least as much emphasis on the labor market data as the inflation data, and given how low unemployment is, that skews, if not hawkish, at least not dovish. Here’s Goldman one more time, from the Q&A section of the note:
Do you agree with the bond market’s dovish reaction to Powell’s speech?
A: No. We disagree, partly because of the speech’s three references to the new study, including the more specific footnotes 16 and 19. More broadly, we see the speech as an endorsement of the Fed’s balanced approach, even in a changing economy. And consistent with the importance of labor market data, Powell’s speech concludes that further gradual increases in the policy rate would “likely be appropriate” if “strong growth in income and jobs continues.”
If Powell will be inclined to prioritize concerns about an overheating labor market in his decision calculus, it suggests that the better the employment data, the more steadfast he’ll be in his inclination to hike.
Guess who won’t like that?