The first Fed speaker of the post-Brexit era delivered a decidedly dovish message. Confirming the expectations of market participants, Federal Reserve Governor Jerome Powell made clear that the Fed was in a holding pattern until the dust settles. Much of the material is similar in content to his May speech, but the shift in emphasis and nuance indicate a substantially policy path.
Powell summarizes the economic situation as:
How should we evaluate our current performance against the dual mandate? I would say that we have made substantial progress toward maximum employment, although there is still some room for improvement. We have more work to do to assure that inflation moves back up to our 2 percent goal.
Both points are important. On the first point, Powell sees evidence of labor market slack in low participation rates, high numbers of part-time workers, and low wage growth. Recent labor reports concern him:
While I would not want to make too much of two monthly observations, the strength of the labor market has been a key feature of the recovery, allowing us to look through quarterly fluctuations in GDP growth. So the possible loss of momentum in job growth is worrisome.
My guess is that they will want to see a string of 2 or 3 solid labor reports before they breathe easier. Still, by acknowledging that the economy is operating near full employment, does he open the door to concerns about inflation? No:
When I was first exposed to macroeconomics in college, more than four decades ago, the view was that inflation was strongly influenced by the amount of slack in the economy. But the relationship between slack and inflation has weakened substantially over the years.
Or, in other words, the Phillips Curve is flat. Not quite flat as a pancake, but pretty darn flat. More important:
In addition, inflation depends importantly on the inflation expectations of workers and firms. A widely shared view among economists today is that, unlike during the 1970s, expectations are no longer heavily influenced by fluctuations in inflation, but are fairly constant, or anchored. For both these reasons, inflation has become less responsive to cyclical changes in the economy.
And what is happening to inflation expectations?
We measure inflation expectations through surveys of forecasters and the general public, and also through market readings on inflation swaps and "breakevens," which represent inflation compensation as measured by the difference between the return offered by nominal Treasury securities and that offered by TIPS. Since mid-2014, these market-based measures have declined significantly to historically low levels. Some of this decline probably represents lower risk of high inflation, or an elevated liquidity preference for much more heavily traded nominal Treasury securities, rather than expectations of lower inflation. Some survey measures of inflation expectations have also trended down.
The signs are worrisome:
Given the importance of expectations for determining inflation, these developments deserve, and receive, careful attention. While inflation expectations seem to me to remain reasonably well anchored, it is essential that they remain so. The only way to assure that anchoring is to achieve actual inflation of 2 percent, and I am strongly committed to that objective.
By downplaying the importance of slack while emphasizing the importance of inflation expectations, he is neutering the primary argument of Fed hawks who insist that approaching full employment necessitates higher interest rates to stay ahead of inflationary pressures. The line about achieving actual inflation of 2 percent could be a nod toward Evans Rule 2.0. Something to keep an eye on.
The impact of Brexit and the subsequent market turmoil is straightforward:
These global risks have now shifted even further to the downside, with last week's referendum on the United Kingdom's status in the European Union. The Brexit vote has the potential to create new headwinds for economies around the world, including our own. The risks to the global outlook were somewhat elevated even prior to the referendum, and the vote has introduced new uncertainties.
And the implication for monetary policy:
It is far too early to judge the effects of the Brexit vote. As the global outlook evolves, it will be important to assess the implications for the U.S. economy, and for the stance of policy appropriate to foster continued progress toward our objectives of maximum employment and price stability.
Notice that he does not warn that rate hikes are coming. Compare to his May speech:
If incoming data continue to support those expectations, I would see it as appropriate to continue to gradually raise the federal funds rate. Depending on the incoming data and the evolving risks, another rate increase may be appropriate fairly soon.
He is wisely now mum on the timing of the next rate hike. More Fed speakers will follow him than not.
But Brexit alone is not the only factor depressing the rate outlook:
I am often asked why rates remain so low now that we are near full employment. A big part of the answer is that, at least for the time being, the appropriate level of rates is simply lower than it was before the crisis. As a result, policy is not as stimulative as it might appear to be. Estimates of the real interest rate needed to keep the economy on an even keel if it were operating at 2 percent inflation and full employment--the "neutral rate" of interest--are currently around zero. Today, the real short term interest rate is about negative 1-1/4 percent, so policy is actually only moderately stimulative. I anticipate that the neutral rate will move up over time, as some of the headwinds that have weighed on economic growth ease.
The Fed increasingly recognizes that policy is not highly accommodative simply because rates are zero. The stance of policy is relative to the real interest rate, and a lower real rate means that policy is actually only "moderately" stimulative. Translation: There is no need to hike rates soon because policy is not particularly accommodative.
Missing now is this warning from May:
There are potential concerns with such a gradual approach. It is possible that monetary policy could push resource utilization too high, and that inflation would move temporarily above target. In an era of anchored inflation expectations, undershooting the natural rate of unemployment should result in only a small and temporary increase in the inflation rate. But running the economy above its potential growth rate for an extended period could involve significant risks even if inflation does not move meaningfully above target. A long period of very low interest rates could lead to excessive risk-taking and, over time, to unsustainably high asset prices and credit growth. Macroprudential and other supervisory policies are designed to reduce both the likelihood of such an outcome and the severity of the consequences if it does occur. But it is not certain that these tools would prove adequate in a financial system in which much intermediation takes place outside the regulated banking sector. Thus, developments along these lines could ultimately present a difficult set of tradeoffs for monetary policy.
By not reiterating this risk, Powell removes an argument to raise rates even as inflation remains below target, the financial stability risk. But how much of a risk is it? If the natural rate of interest is lower then the potential for financial market instability is also lower for a given interest rate. Or, in other words, since monetary policy is not as accommodative as previously believed, the risk of financial instability is lower.
Bottom Line: Powell embraces the lower real interest rate story as a reason that monetary policy is only moderately accommodative, warns that downside risks are rising, replaces expectations of a rate hike in the imminent future with only guidance that rates will be appropriate to foster economic growth, and drops concerns about the risks of a sustained low rate environment. The key takeaway - no expectation that an imminent rate hike will be needed. Gradual to glacial to just nothing.