FedSpeak: Breaking Down Past and Present Fed Policy

The former Federal Reserve Chair Alan Greenspan once famously said, “I know you think you understand what you thought I said, but I'm not sure you realize that what you heard is not what I meant.”

Said more simply, the maestro meant that if you think you’ve understood what he said, you did not. Perhaps this is because he did not want to give clear signals to anyone! CNBC famously used to track how large his briefcase looked heading into meetings because they were so starved for insight.

Luckily for us, more recent Fed officials have made clear communication with the public as an explicit goal. As a result, investors are paying more attention to the words of Fed representatives.

And because Fed officials know investors place a lot of importance on their statements, they keep their messaging consistent and choose their words carefully despite communicating more frequently.

Ultimately, investors care when and how much the Fed will change short-term interest rates. So, generally any messaging changes that might give a clue to the Fed’s interest rate policy are grabbing many investors’ attention.

Since 1977, The Fed’s stated policy goals are often referred to as its dual mandate:

1. Keep prices stable
2. Maintain maximum sustainable employment

Sounds simple? Not quite. Mainly because in the past those two goals were seen as being directly at odds with each other.

Below is a picture of the famous model or framework used by the Fed to balance these two objectives. It is famously known as the Phillips curve.

The Phillips curve

The reason these two objectives were considered at odds with each other based on economic principles is illustrated as follows:

As the unemployment rate moves lower, there is more competition for workers. So, when the unemployment rate is low, employers begin to outbid each other for workers, leading to an increase in wages. But business owners will only bid more for workers if it is profitable for them to do so. That may mean that prices need to go up, leading to inflation.

In terms of inflation, the Fed defined stable prices as 2% inflation in 2012. That is a recent clarification in the scheme of over a century of policy making.

The Fed has historically been so worried about inflation that they would attempt to stop it — at the expense of a lower unemployment rate — when inflation increased to 2%. This is important. The Federal Reserve set a firm line in the sand and would not wait to see higher inflation in official data sets before acting to slow inflation.

While the Fed’s two main policy goals have not changed, the devil is in the details.

The Fed has stated that employment is currently more of an important focus than price stability as the U.S economy recovers from the Covid-19 pandemic. See the image below where the Fed crosses out a reference to employment that came after inflation in order to move it in front of inflation.

The Fed has also emphasized that employment gains must be inclusive, meaning communities who have higher levels of unemployment need to see outsized gains in job creation before inflation concerns begin to dictate policy again.

Even before the economic crisis resulting from the Covid-19 pandemic, Congresswoman Alexandria Ocasio-Cortez, questioned the value of the Phillips curve when Fed Chairman Jerome Powell was brought up to testify in 2019:

‘Ocasio-Cortez argued that the theory, which suggests that low unemployment can accelerate inflation, doesn't capture what's happening in the economy. Powell responded to Ocasio-Cortez's questioning by confirming that the economy can handle "much lower unemployment than we thought" without negatively affecting inflation.’

The dismissal of the Phillip’s curve even earned praise from Trump’s economic advisor at the time, Larry Kudlow. This bipartisan dismissal of the Phillips curve across the political spectrum may allow the Federal Reserve to push the unemployment rate lower in the future than previously thought possible.

Further compounding the change in inflation policy is how the Fed will define stable prices moving forward, as seen in this CNBC headline which plainly states, “Powell announces new Fed approach to inflation that could keep rates lower for longer.”

The article that followed the headline expressed that the “Federal Reserve announced a major policy shift Thursday, saying that it is willing to allow inflation to run hotter than normal in order to support the labor market and broader economy. … That means it will allow inflation to run ‘moderately’ above the Fed’s 2% goal ‘for some time’ following periods when it has run below that objective.”

This is a big change. As mentioned earlier, the Federal Reserve only named its 2% inflation target in 2012. Now the Fed is saying that inflation can go beyond 2% because inflation over the prior decade was persistently lower.

Inflation remains under Fed target

As mentioned above, the Federal Reserve’s primary lever for balancing its policy goals is the overnight lending rate it charges banks.

Investors, banks, consultants, media pundits and policy makers, among many others, spend an extensive amount of time trying to deduce whether the Fed will change the amount it charges banks overnight in its quest to fulfill its dual mandate.

According to the Wall Street Journal, “the Fed doesn’t foresee raising its benchmark fed-funds rate from near zero until three conditions have been met: a broad range of statistics indicate that the labor market is at maximum strength, inflation has hit its 2% target and forecasters expect inflation to remain at that level or higher.”

In January, Chairman Powell stated that inflation concerns during the economic recovery from the pandemic are “a transient thing that we think will pass.”

After the last Fed policy announcement, Chairman Jerome Powell released an op-ed in the Wall Street Journal which stated, “the recovery is far from complete, so at the Fed we will continue to provide the economy with the support that it needs for as long as it takes.”

In other words, Chairman Powell is saying that the Fed will continue to keep rates down regardless of inflation until the economy has recovered, which includes employment numbers in the US.

Scott Minerd, the Chief Investment Officer of Guggenheim Partners, summarized Powell’s statement in a series of tweets:

“2.2% inflation will not be high enough! And 3.5% unemployment will not be low enough! Powell made it clear today we shouldn’t expect action earlier than already indicated. He said it took 7 years after the Great Financial Crisis before the Fed tightened, telegraphing that existing guidance may be too hawkish. It will be virtually impossible for Powell to walk this position back if inflation were to spike for an extended period. He definitely put a stake in the ground.”

Pretty strong words. To put it simply, some market participants feel the Fed has backed itself into a corner if inflation does ultimately become a more pressing concern. For more information on inflation, see our pieces on Inflation and Growth vs Value here.

Other policy makers disagree with this harsh criticism of the Fed’s current framework. Former Fed Chair and current Treasury Secretary Janet Yellen stated, “I’ve spent many years studying inflation and worrying about inflation. And I can tell you we have the tools to deal with that risk if it materializes.”

While it may or may not be true that the Fed has “the tools” to deal with inflation, the question in light of its new employment goals is whether or not policy makers have “the guts” to take a stand if inflation becomes a problem and the Phillip’s curve starts to matter again.

Some argue it never went away if you look closely:

While investors listen very closely to the Federal Reserve for clues about Fed policy and what it means for interest rates, the Fed currently seems to be favoring employment recovery despite its two main concerns that guide decision-making around the mandate of stabilizing employment and inflation.

In the past, the Fed relied on the Phillips curve to guide them in balancing these concerns when making policy decisions. Recently the Fed has decided that the Phillips curve is not as useful as it was in the past, and other policy makers agree with them.

The Fed has begun to prioritize employment above inflation, especially employment in communities that have been slow to participate in the economy. This prioritization of employment by the Fed started before the pandemic but has been cemented by the need for the economy to recover.

Critics of this Fed policy shift are worried that the monetary authority’s publicly stated priorities have backed them into a corner. Even if inflation were to pick up, it would be highly unpopular among Democrats and Republicans alike to slow employment gains.

Fed Chair Jerome Powell has been steadfast that any inflation seen this year is “transitory” due to the rapid pickup in economic activity due to the pandemic. He says inflation concerns are overblown.

Investors will be listening closely to see if he changes his stance.