In his Jackson Hole speech on Friday, Fed Chair Powell made the case for a continued cautious and gradual approach in raising rates, pointing particularly to uncertainty around estimates of the NAIRU, or the natural rate of unemployment. While there was much to digest from Powell’s speech, the key takeaway for us was that the level of unemployment relative to the NAIRU is not a reliable signal on which to base policy decisions, and that policymakers should instead focus on a range of signals. Powell pointed to the policy mistakes of the 1960s, when the NAIRU estimate was in retrospect too low, and unemployment was allowed to fall to levels that led to a de-anchoring of inflation expectations. Instead, Powell points for instance to inflation expectations as a more powerful signal for monetary policy. In addition, he repeated his line from the June FOMC press conference that the previous two recessions were triggered by financial instability rather than high inflation, and so a focus on the buildup of financial excesses should also figure prominently into policymakers’ decisions.
What does this mean for the path of monetary policy? In the current environment, with unemployment well below current NAIRU estimates, Powell is essentially arguing against the need to for the Fed to hike rates aggressively in response to this, so long as inflation expectations remain well-anchored (as they have done). Supporting this view, Powell also remarked that there ‘does not seem to be an elevated risk of overheating’, which was in part a result of ‘the ongoing normalization process’. In order to strike a balance between the risk of doing too much versus the risk of doing too little, we expect the Fed to continue to steer the fed funds rate gradually towards its estimate of neutral (2.9%), and look for a further four 25bp rate hikes by next June. (Bill Diviney)