Two Years Later, ‘A Completely Unbalanced Situation’

The amount of digital ink devoted to Jackson Hole over the past several days was remarkable. I’m just as “guilty” as anyone else. It’s preemptive tasseography — reading the tea leaves of a speech no one has even heard yet.

The effects of Fed tightening are starting to show up. The lags may be “long and variable,” but some of the impact is manifesting in the economy and corporate guidance. A preliminary read on services sector activity for August was disastrous, for example, and higher mortgage rates “tapped the brakes” on the housing market, as Neel Kashkari put it Tuesday, during remarks to the Wharton Club of Minnesota.

Kashkari warned on inflation expectations and name-dropped Volcker. If inflation stays at 8% or 9%, the Fed runs the risk of “very bad outcomes,” he said, calling the juxtaposition between the labor market and inflation “a completely unbalanced situation.”

It’s tragic, in a way. This is exactly what they wanted. Just not to this degree. The adoption of “flexible average inflation targeting” meant countenancing inflation overshoots in order to ensure consumer expectations didn’t go the Japan route, and also to facilitate a shift towards a more literal interpretation of the term “full employment” on the assumption that the Phillips curve was more dead than resting. And now, here we are.

Note that the Fed could’ve held off on adopting AIT considering ambiguity around the evolving macro circumstances. But they went ahead. Powell, you’ll recall, made the announcement during a virtual address “at” Jackson Hole two years ago, during the middle of the pandemic.

Looking back on it now, my commentary was ominous, naive and prescient all at once. “In a hotly-anticipated speech that could echo for years, Powell expounded on the Fed’s policy framework review, which took on an extra sense of urgency when the pandemic ushered in a deflationary supernova, even as it introduced new upside risks for inflation down the road,” I wrote, on August, 27, 2020.

Suffice to say those “upside risks” materialized. And not so far “down the road.”

Some of Powell’s remarks from that day are cringeworthy with the benefit of hindsight. “It reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” he said.

At the time, a chart of the difference between the Fed’s target and realized inflation appeared to make the case. Price growth undershot consistently for a dozen years. Now, just 24 months later, the Fed is indeed “averaging” up — and “big league,” as one former US government official who enjoys archiving top secret documents in retirement might put it.

What you see in the figure (above) isn’t what officials had in mind with AIT. While the plan to implement a version of inflation-targeting in the US was in the works before the pandemic, the Fed was six months into COVID by the time they made it official. That suggests they were totally bereft in analyzing the evolving conditions across supply chains and hadn’t the faintest sense of what the labor market might look like post-lockdowns.

At the time, JonesTrading’s Mike O’Rourke was characteristically skeptical. “We describe this as codifying the ‘Powell Put’,” he said, of Powell’s 2020 Jackson Hole speech, inaugurating AIT. Next, he posed a rhetorical question: “Over the past two decades, core PCE inflation has average 1.72% and been above 2% only 27% of the time — Does that mean the Fed does not need to raise interest rates for the next century?” He was being sarcastic, of course.

The Fed spent decades taking credit for an inflation undershoot that had more to do with secular disinflationary forces than monetary policy. As I’ve suggested previously, the Fed’s greatest contribution to disinflation over the past 30 years wasn’t adept policymaking, but rather the fallout from burst bubbles of their own creation.

One consequence of the long period of below-target price growth is the absence of inflation-fighting credentials. We tend to couch Fed commentary in language that suggests the Committee is currently trying to reestablish or preserve its reputation as a check on runaway price growth. Another way to look at it is that they’re trying to establish it for the first time in modern history. If that characterization makes you feel old (i.e., if you’re uncomfortable with the notion that “modernity” no longer includes the 70s, or even the early 80s, please accept my apologies and know that I sympathize).

Writing three days before this year’s Jackson Hole, JonesTrading’s O’Rourke made the point. “The market will continue to embrace dovish pivot hopes because Chairman Powell and the modern Federal Reserve don’t have inflation fighting credibility,” he wrote, adding that “the only way to establish credibility is by repeatedly dashing those hopes.”