Last week, Fed Chair Jerome Powell delivered a speech at the annual central bank symposium at Jackson Hole, Wyoming. The speech was highly anticipated and flagged in the media before it was delivered as “profoundly consequential” in relation to the way the Fed operates monetary policy. The changes follow a two-year review and were centered on the need to adapt monetary policy to “the new changes that arise” from the multi-year period of low growth, low interest rates, and low inflation in the face of what was before covid-19, a strong labour market. The conclusion to the report was that the interpretation of the Fed’s mandate of price stability and maximum employment would evolve to a more “broad based and inclusive goal” for maximum employment and the adoption of “average inflation targeting,” which means that they will aim for inflation moderately above 2% for some time following periods when inflation has been below that level.
This change was highly anticipated by markets and hence there were no fireworks on its release. However, this does not mean it was not an important milestone on a journey that has been underway for some time and still has much road ahead. Our key observations on this are detailed below.
The move gives an official framework to what the Fed has already been doing for years anyway, which is to become more active and creative in its efforts to combat persistent undershooting of inflation targets and falling long-term inflation expectations. The deflationary force is both structural (from debt, demographics, technology) and now cyclical (from the hit to economies from covid-19). It sets the stage for an even more dovish Fed in the years ahead.
However, just because the Fed has set a higher target for inflation, why should that matter when it hasn’t been able to meet a lower one for years? Is a high jumper that raises the bar after two fails to stay in the competition more likely to make the higher height? In this case, maybe. In the period after the Global Financial Crisis in 2008, the central banks have continued to be highly accommodative and supportive of markets. However, on the fiscal side there was a strong wave of conservatism to bring deficits under control. In the US, the TEA party wing of the Republicans was a powerful voice and even the Democrats under Obama prioritised getting the fiscal house in order. In the UK, we had the austerity budgets of the Osborne Chancellorship and in Europe, the 3% budget rule and a continent led by Germany added up to virtually zero fiscal stimulus. This time the opposite is true. Any politician that even breathes the word austerity will be out of office in a heartbeat.
The importance of Jackson Hole this year is that it paved the way for what is to come. Unlike the post-2008 period, both monetary and fiscal will be leaning hard in the same direction. Monetary policy’s main role going forward will be as a facilitator of fiscal policy. Thus far the Fed has shied away from committing to yield curve control. However, that is because we have yet to see any real upward pressure on rates. I think we can be quite sure that if they were to rise in any meaningful way the Fed will step in. In the US, the upcoming election complicates the near-term outlook. However, whichever party is in power in the next presidential term, both the monetary and fiscal arms of governments will be pulling in the same direction. Modern Monetary Theory is already a reality. To the extent that there are still gaps in demand as a result of covid-19, it is likely that inflation will remain subdued in the near term. However, Jackson Hole 2020 will act as a date stamp for when there was a step change in policy which will likely have very different outcomes to the previous cycle.