Is this the end of Zero?

U.S. Federal Reserve Chairman Jerome Powell addressed the National Association of Business Economists last night, providing a clear picture of the Fed’s view of the economy, the impact of Russia’s invasion and the likely path forward for monetary policy. As it has important implications for investors it is essential listening or reading.

Watch Chair Powell’s address to NABE

Read the transcript of Chair Powell’s address to NABE

Introductory remarks

Beginning his speech Jerome Powell noted the Fed’s dual mandate to promote stable prices and maximum employment. Keep that in mind as you read on.

Following are a few pertinent excerpts from Powell’s introductory comments.

From that standpoint [the Dual Mandate] the current picture is plain to see – the labour market is very strong and inflation is “much too high.

“There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level and then to move to more restrictive levels if that is what is required to restore price stability.” “We are committed to restoring price stability while preserving a strong labour market.”

At the FOMC meeting last week the Federal Reserve raised their policy interest rate and said further rate increases are appropriate to reach their policy objectives. At the same meeting the Fed also said it will begin to reduce the size of its balance sheet “at a coming meeting.” And at the press conference afterward the FOMC meeting, the Fed Chair noted it could begin reducing the size of its balance sheet as soon as at the next meeting in May, while noting the decision has not yet been made.

These changes “represent a substantial firming in the stance of policy with the intention of restoring price stability.”

Economic Picture – Labor Market

Powell began the first part of his speech, on the subject of current economic conditions, by acknowledging the “remarkable benefits of an extended period of strong labor market conditions”, which are the result of the historically long expansion that ended with the arrival of the pandemic. Powell noted the Fed’s intention “to foster another long expansion in order to realize those benefits again.

Powell noted the labor market is “very strong” and “extremely tight.”

To begin with employment, in the last few years of the historically long expansion that ended with the arrival of the pandemic, we saw the remarkable benefits of an extended period of strong labor market conditions. We seek to foster another long expansion in order to realize those benefits again.

“The labor market has substantial momentum. Employment growth powered through the difficult Omicron wave, adding 1.75 million jobs over the past three months. The unemployment rate has fallen to 3.8 percent, near historical lows, and has reached this level much faster than anticipated by most forecasters (figure 1). While disparities in employment remain, job growth has been widespread across racial, ethnic, and demographic groups.

“By many measures, the labor market is extremely tight, significantly tighter than the very strong job market just before the pandemic. There are far more job openings going unfilled today than before the pandemic, despite today’s unemployment rate being higher. Indeed, there are a record 1.7 posted job openings for each person who is looking for work. Record numbers of people are quitting jobs each month, typically to take another job with higher pay. And nominal wages are rising at the fastest pace in decades, with the gains strongest for those at the lower end of the wage distribution and among production and nonsupervisory workers (figure 2).

“It is worth considering why the labor market is so tight, given that the unemployment rate is actually higher than it was before the pandemic. One explanation is that the natural rate of unemployment may be temporarily elevated, so wage pressure is greater for any given level of unemployment. The sheer volume of hiring may have taxed the capacity of the market to bring workers and jobs together. The Delta and Omicron variants complicated hiring, and the strong financial position of households may have allowed some to be more selective in their job search. Over time, we might expect these factors to fade, reducing pressure in the job market.

“A second source of labor market tightness is that the labor force participation rate dropped sharply in the pandemic and has only partly recovered. As a result, the labor force remains below its pre-pandemic trend. Total demand for labor, measured by total employment plus posted job openings, has substantially recovered and far exceeds the size of the workforce.”

Economic Picture – Deteriorating Inflation Outlook

“Turning to price stability, the inflation outlook had deteriorated significantly this year even before Russia’s invasion of Ukraine.

“The rise in inflation has been much greater and more persistent than forecasters generally expected. For example, at the time of our June 2021 meeting, every Federal Open Market Committee (FOMC) participant and all but one of 35 submissions in the Survey of Professional Forecasters predicted that 2021 inflation would be below 4 percent. Inflation came in at 5.5 percent.

“For a time, moderate inflation forecasts looked plausible—the one-month headline and core inflation rates declined steadily from April through September. But inflation moved up sharply in the fall, and, just since our December meeting, the median FOMC projection for year-end 2022 jumped from 2.6 percent to 4.3 percent.

“Why have forecasts been so far off? In my view, an important part of the explanation is that forecasters widely underestimated the severity and persistence of supply-side frictions, which, when combined with strong demand, especially for durable goods, produced surprisingly high inflation.

“The pandemic and the associated shutdown and reopening of the economy caused a serious upheaval in many parts of the economy, snarling supply chains, constraining labor supply, and creating a major boom in demand for goods and a bust in services demand. The combination of the surge in goods demand with supply chain bottlenecks led to sharply rising goods prices. The most notable example here is motor vehicles. Prices soared across the vehicles sector as booming demand was met by a sharp decline in global production during the summer of 2021, owing to shortages of computer chips. Production remains below pre-pandemic levels, and an expected sharp decline in prices has been repeatedly postponed.

“Many forecasters, including FOMC participants, had been expecting inflation to cool in the second half of last year, as the economy started going back to normal after vaccines became widely available. Expectations were that the supply-side damage would begin to heal. Schools would reopen—freeing parents to return to work—and labor supply would begin bouncing back, kinks in supply chains would begin resolving, and consumption would start rotating back to services, all of which could reduce price pressures. While schools are open, none of the other expectations has been fully met.

The Future for Fed Policy (‘Currently!)

As the magnitude and persistence of the increase in inflation became increasingly clear over the second half of last year, and as the job market recovery accelerated beyond expectations, the FOMC pivoted to progressively less accommodative monetary policy. In June, the median FOMC participant projected that the federal funds rate would remain at its effective lower bound through the end of 2022, and as the news came in, the projected policy paths shifted higher. The median projection that accompanied last week’s 25 basis point rate increase shows the federal funds rate at 1.9 percent by the end of this year and rising above its estimated longer-run normal value in 2023. The latest FOMC statement also indicates that the Committee expects to begin reducing the size of our balance sheet at a coming meeting. I believe that these policy actions and those to come will help bring inflation down near 2 percent over the next 3 years.

“As always, our policy projections are not a Committee decision or fixed plan. Instead, they are a summary of what the FOMC participants see as the most likely case going forward. The events of the past four weeks remind us that, in tumultuous times, what seems like the most likely scenario may change quite quickly: Each Summary of Economic Projections reflects a point in time and can become outdated quickly at times like these, when events are developing rapidly.

Three Questions about the likely evolution of Fed Monetary Policy

Question One: How will fallout from the invasion of Ukraine affect the economy and monetary policy?

Russia is one of the world’s largest producers of commodities, and Ukraine is a key producer of several commodities as well, including wheat and neon, which is used in the production of computer chips. There is no recent experience with significant market disruption across such a broad range of commodities. In addition to the direct effects from higher global oil and commodity prices, the invasion and related events are likely to restrain economic activity abroad and further disrupt supply chains, which would create spillovers to the U.S. economy.”

Jerome Powell noted however, as we have done in the article: Inflation fears will soon fade…, the US is far less reliant on oil than it was in the 1970s and indeed is now the largest producer of oil in the world.  On a net basis, oil shocks do weigh on the US economy but by far less than in the ‘70s.

Russia’s invasion of Ukraine may have significant effects on the world economy and the U.S. economy. The magnitude and persistence of these effects remain highly uncertain and depend on events yet to come.”

Question Two: How likely is it that monetary policy can lower inflation without causing a recession?

Our goal is to restore price stability while fostering another long expansion and sustaining a strong labor market. In the FOMC participant projections I just described, the economy achieves a soft landing, with inflation coming down and unemployment holding steady. Growth slows as the very fast growth from the early stages of reopening fades, the effects of fiscal support wane, and monetary policy accommodation is removed.

“Some have argued that history stacks the odds against achieving a soft landing, and point to the 1994 episode as the only successful soft landing in the postwar period. I believe that the historical record provides some grounds for optimism: Soft, or at least soft-ish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.”

“No one expects that bringing about a soft landing will be straightforward in the current context — very little is straightforward in the current context,” said Powell.

Question Three: What will it take to restore price stability?

“…if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so. And if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.”

“While we cannot measure longer-term [inflation] expectations directly, we monitor a variety of survey- and market-based indicators. In the recent period, short-term inflation expectations have, of course, risen with inflation, but longer-run expectations remain well anchored in their historical ranges.”

“The added near-term upward pressure from the invasion of Ukraine on inflation from energy, food, and other commodities comes at a time of already too high inflation. In normal times, when employment and inflation are close to our objectives, monetary policy would look through a brief burst of inflation associated with commodity price shocks. However, the risk is rising that an extended period of high inflation could push longer-term expectations uncomfortably higher, which underscores the need for the Committee to move expeditiously as I have described.”

Today, as I have discussed, the labor market is very strong. But, to end where I began, inflation is much too high. We have the necessary tools, and we will use them to restore price stability.”


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