At the moment, gradual rate hikes remain appropriate, given no signs that inflation will accelerate beyond 2%, despite broad risk factors, Federal Reserve Board Chair Jerome Powell said Friday.
A “gradual process of normalization remains appropriate,” Powell said in a speech at the symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyo., according to prepared text released by the Fed. “As always, there are risk factors abroad and at home that, in time, could demand a different policy response, but today I will step back from these.”
The Federal Open Market Committee faces two risks: moving too fast and stifling economic expansion and moving too slowly and allowing the economy to overheat, he said.
“[T]he job of avoiding these errors is made challenging today because the economy has been changing in ways that are difficult to detect and measure in real time,” he said.
With unemployment “well below estimates of its longer-term normal level,” Powell said, the indication is for fast hikes to stave off “overheating and inflation,” while low inflation suggested the Fed shouldn’t be tightening or else it risks ending the expansion.
“I see the current path of gradually raising interest rates as the FOMC’s approach to taking seriously both of these risks,” Powell said. “While the unemployment rate is below the Committee’s estimate of the longer-run natural rate, estimates of this rate are quite uncertain. The same is true of estimates of the neutral interest rate. We therefore refer to many indicators when judging the degree of slack in the economy or the degree of accommodation in the current policy stance. We are also aware that, over time, inflation has become much less responsive to changes in resource utilization.
“While inflation has recently moved up near 2%, we have seen no clear sign of an acceleration above 2%, and there does not seem to be an elevated risk of overheating. This is good news, and we believe that this good news results in part from the ongoing normalization process, which has moved the stance of policy gradually closer to the FOMC’s rough assessment of neutral as the expansion has continued. As the most recent FOMC statement indicates, if the strong growth in income and jobs continues, further gradual increases in the target range for the federal funds rate will likely be appropriate.”
Powell touched on “longer-term structural challenges that are mostly beyond the reach of monetary policy,” including slow real wage growth, a decline in economic mobility, the growing federal budget deficit, and low-productivity.
Pinning down the natural rate of unemployment (or u-star), the neutral real rate of interest (or r-star), and the inflation objective (or pi-star) is difficult, and “changing assessments have big implications,” he said.
With normalization under way, “projections of the natural rate of unemployment fell roughly 1 full percentage point, as did assessments of the neutral interest rate. Estimates of the potential growth rate of GDP slipped about 1/2 percentage point,” he noted.
These changes are important. “For example, the 1 percentage point fall in the neutral interest rate implies that the federal funds rate was considerably closer to its longer-run normal and, hence, that policy was less accommodative than thought at the beginning of normalization,” Powell said. “The 1 percentage point fall in the natural rate of unemployment implies at present that about 1.6 million more people would have jobs when unemployment is at its longer-run level.”
He suggested the changes are attempts to reconcile projections with incoming data. “For example, as the unemployment rate fell toward, and then below, estimates of its natural rate, many expected inflation to move up. When inflation instead moved sideways, a reasonable inference was that the natural rate was lower than previously thought.”
When GDP growth didn’t match expectations based on the decline in unemployment, it “raised the question of whether that shortfall was temporary — perhaps due to headwinds from the crisis — or was part of a new normal,” Powell said.
“These assessments of the values of the stars are imprecise and subject to further revision,” he noted.
