Later on, I’ll have more to say about the Fed’s new approach to policy, but this portion of Jay Powell’s speech caught my eye:
[O]ur revised statement says that our policy decision will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level” as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.
In earlier decades when the Phillips curve was steeper, inflation tended to rise noticeably in response to a strengthening labor market. It was sometimes appropriate for the Fed to tighten monetary policy as employment rose toward its estimated maximum level in order to stave off an unwelcome rise in inflation. The change to “shortfalls” clarifies that, going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals.
Keynesians have traditionally held a “Phillips Curve” model of inflation. They believe that inflation is caused by a very strong job market. In contrast, monetarists have argued that inflation is caused by excessive money printing and that economic growth is actually deflationary, ceteris paribus. Henceforth, the Fed will abandon Phillips curve models and instead look for “signs of unwanted increases in inflation”. To older monetarists, that would be excessive money supply growth. To market monetarists, that would be a rise in market forecasts of inflation.
I don’t believe the Fed will pay much attention to the monetary aggregates when forecasting inflation, as old style monetarism did not perform well during the Great Recession. I also see this statement as an implicit rejection of the Keynesian approach to inflation forecasting, which failed in the late 2010s, and a tacit acceptance of the market monetarist approach, which was more successful during the late 2010s.
READER COMMENTS
Garrett
Aug 27 2020 at 11:54am
Sounds like a great reason to stop communicating monetary policy goals in terms of inflation and instead talk about (for example) nominal income growth. I seem to recall a certain economist raising this issue a while back…
Scott Sumner
Aug 27 2020 at 1:25pm
Very good point.
Ahmed Fares
Aug 27 2020 at 12:19pm
“I also see this statement as an implicit rejection of the Keynesian approach to inflation forecasting, which failed in the late 2010s…”
In a globalized economy, what matters is global slack, not domestic slack. Here is a quote:
[quote]
There are two competing explanations for the demise of the standard, domestic, accelerationist Phillips curve. The first is that because inflation expectations have become firmly anchored at the target (no one doubts the Fed’s willingness or ability to keep inflation in check), the inflation process has mutated so that the relationship that works now is between domestic slack and the level of inflation rather than changes in inflation. There is some evidence to support this hypothesis.
The competing explanation is the Global Slack Hypothesis which says that due to the integration of global markets, what now drives inflation is not domestic slack but rather global slack. Due to competition from global rivals, domestic producers in the tradable sector cannot raise prices when the domestic labor market tightens and wage pressures build. Instead, they either rebalance their global supply chains and off-shore production; or they lose business to their foreign rivals. In either case, domestic inflation is determined as much by global slack as by domestic slack.
The evidence is mounting that the second explanation is the right one. What is especially compelling is the evidence that global slack is statistically significant in ALL countries for which data is available while domestic slack is significant is NONE since 2000. See Figure 3. The last column corresponds to global slack (“foreign gap”); no stars means the variable is not significant; three means it is significant at the 1 percent level.
[end quote]
source: https://policytensor.com/2016/12/17/global-slack-us-inflation-and-the-feds-policy-error/
Scott Sumner
Aug 27 2020 at 1:27pm
You said:
“In a globalized economy, what matters is global slack, not domestic slack.”
Not at all. You don’t even need to look at places like Zimbabwe; Turkey, India and Brazil will do just fine. Inflation is caused by domestic monetary policy.
Jose Pablo
Sep 1 2020 at 2:13pm
The premise behind this idea of the “global slack” (apart from assuming the Keynesian and not the monetary view on inflation) is that global markets are the relevant ones fixing prices and so the “global slack” is the relevant input for a global Phillips curve.
Apart from the empirical evidence that not all the countries have the same inflation, but all of them share the same “global”, the problem with this reasoning is that the extend of globalization is a myth. Good for selling newspaper, cocktail parties chatting and harvesting votes from scared populations, but difficult to hold when you analyze the data.
https://www.weforum.org/agenda/2019/01/why-the-world-is-not-as-globalized-as-you-think/
Michael Rulle
Aug 27 2020 at 12:27pm
Well, he seems to be committing to what he has gradually been moving toward. So one has to really be optimistic—-he knew this was important—which is why he “pre-announced” his announcement.
I don’t want to bring politics into this—-but I do think it may be relevant. There is a movement from the more extreme left (I have no idea what their influence is—nor what a Biden/Harris Dem Senate might think) in favor of MMT, which would be a huge setback.
So would Powell be replaced for an MMter? Then what? 70s/80s?
My real point is Powell rejecting the continual curve fit Phillips Curve is an enormous step forward–and if Monetary policy is as important as MM believes—which evidence points to—then a switch back to Keynes, or worse, MMT , would not be good–to say the least.
Ahmed Fares
Aug 27 2020 at 1:07pm
“then a switch back to Keynes, or worse, MMT , would not be good–to say the least.”
MMT is 90% descriptive, 10% prescriptive. MMT simply describes how the economy operates. We’re always in an MMT world.
Scott Sumner
Aug 27 2020 at 1:29pm
MMT has no influence at all among influential economists, policymakers, etc. It’s a fringe cult.
Thomas Hutcheson
Aug 27 2020 at 1:40pm
“Keynesians have traditionally held a “Phillips Curve” model of inflation. They believe that inflation is caused by a very strong job market.”
Not exactly. Keynesians have believed that monetary policy sufficient to produce full employment would produce inflation and were willing to accept a degree of inflation as the price. Presumably that is where the Fed’s 2% PCE target comes from. But in practice, “Keynesians” have not recommended the policies followed by the Fed since 2008 of allowing inflation to fall below target. If the Fed now shifts to actually carrying out it’s mandate, that will be an adoption of, not a rejection of a “Keynesian” position.
Scott Sumner
Aug 28 2020 at 12:48pm
You said:
“Not exactly. Keynesians have believed that monetary policy sufficient to produce full employment would produce inflation and were willing to accept a degree of inflation as the price.”
No, they believe that full employment is evidence that there’s been an expansionary monetary policy—an important distinction.
You said:
“But in practice, “Keynesians” have not recommended the policies followed by the Fed since 2008 of allowing inflation to fall below target.”
So Janet Yellen (who is certainly a prominent Keynesian) opposed the Fed policies of 2014-18, even as she was Fed chair? Maybe, but I’m not convinced.
Ike Coffman
Aug 27 2020 at 3:06pm
Monetary policy is actually counter-productive in periods of low demand. The Fed simply doesn’t have a good way to reach the small businesses and service workers most impacted by this economic slowdown. In my opinion, what worked to create the V shaped recovery was fiscal policy, which has to implemented by congress. As long as the stock market is booming, this administration sees no reason to give into the demands of a democratic congress, and we will continue to have a stalemate.
What I think has to happen is the exact opposite of current monetary policy, at least temporarily. If the Fed were to jack interest rates up, the market would decline, effectively forcing the executive branch and the legislative branch back to the bargaining table. It is not a negative for most of the working class if the investor class feels a little of the pain they feel.
Thomas Hutcheson
Aug 28 2020 at 8:55am
The Fed does too have the tools to affect “main street:” make the alternatives to not pushing loans out to keep small businesses in business, landlords/mortgage holders not negotiating with renters/mortgagees rather than evict or foreclose less attractive. Removing IOR would be a necessary but not a sufficient step.
The Fed needs to explain that to deal with the recession they are going to need to crink inflation up beyond the long run target for the price level trajectory.
Does anyone know why the Fed does not have a 1 or 3 year TIPS? The breakeven rate on these would be useful indicators for the Fed and investors.
Scott Sumner
Aug 28 2020 at 12:50pm
You said:
“Monetary policy is actually counter-productive in periods of low demand.”
So the US should switch to a barter economy when demand is low? Because barter is the only alternative to monetary policy.
And don’t say “you know what I meant”. I don’t know what you mean when you talk about not doing monetary policy.
Justin Irving
Aug 28 2020 at 9:29am
Interesting observation. I’d seen the words “inflation expectations” and was taking the speech to mean Powell endorsed a New Keynesian model wherein a New Keynesian Philips Curve lies at the center of the model, mapping the real GDP output gap to inflation and inflation expectations. Seems much more intuitive to put income/spending expectations at the core of the model (Market Monetarism) as spending is clearly much more important than inflation (a substantially subjective, useful, statistical fiction), and spending/income expectations are hands down the primary factor, on which households/firms/governments make micro decisions. But perhaps the glass-half-full take, or the more important take, in from this speech is the movement away from this bizarre, antiquated Old Keynesian model.
It’s probably a very big deal.
James Alexander
Aug 28 2020 at 5:58pm
Why was Powell so wordily mealy-mouthed? One of the papers at Jackson Hole said the public never understands monetary policy, no wonder when it is expressed like this by Powell. He seems like a blogger outside the Fed saying what the Fed should do rather than being the man responsible for implementing it.
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