The work of the Federal Reserve, I believe, is getting harder. And, I believe that the Chairman of the Board of Governors of the Fed, Jerome Powell, recognizes the fact.
For one, Mr. Powell realizes that the old economic models used in the Fed’s policy making aren’t really that helpful any more.
In a speech given last Friday at the Fed’s annual conference at Jackson Hole, Wyoming, Mr. Powell gave us his view of how current monetary policy should be made.
In the first half of the speech, Mr. Powell focused upon what he called “the stars,” the focal point of most Federal Reserve decision making in recent years.
The stars refers to economic variables that were nothing more than the equilibrium solutions to the economic models that became the focal point for Federal Reserve policy goals.
For example there is u * (pronounced “u star”) that represents the natural rate of unemployment. It is the equilibrium rate of unemployment that would exist if the economy were determined to be at “full employment.”
Then there is r * (or “r star”) which is the neutral real rate of interest, or the equilibrium real rate of interest that would exist if the economy were at a full employment level.
And, finally, there is π * (or “pi star”) which is the Fed’s inflation objective.
Mr. Powell describes how these are used: “If inflation is higher than π *, raise the real federal funds rate relative to r *. The higher real interest rate will, through various channels, tend to moderate spending by businesses and households, which will reduce upward pressure on prices and wages as the economy cools off.”
One problem with this Mr. Powell alludes to is that these are conceptual models of the economy based upon historical data that are assumed to have an equilibrium position.
First, the world is changing and the historical data used in the models are generally “out-of-date.” Secondly, the world is hardly ever in equilibrium and is generally moving as a result of current out-of-equilibrium conditions.
Mr. Powell, suggests in his speech that monetary policy needs to be made on the basis of lots of current data where the policy makers need to proceed incrementally.
Policy makers need to avoid errors of “moving too fast” and causing further destabilization or “moving too slowly” and letting events get ahead of you. The concern here is with the creation of “unintended consequences” that might exacerbate, in one way or another, current conditions.
“No single, simple approach to monetary policy is likely to be appropriate across a board range of plausible scenarios.”
Mr. Powell is not a trained economists and he apparently is a pragmatist when it comes to policy making.
Furthermore, the world has changed and business leaders, government policymakers, and economists are working hard to understand how the world is working today, what policy makers can or can’t do, and what results are possible.
Everyone seems to be struggling with this problem. The "new" Modern Corporation is just one of the issues policy makers face. A recent article in the Financial Times discusses How “Central Europe is Running Out of Steam,” and how things just don’t work the way they once did.
As a consequence, economic growth has not been able to grow as fast as people would like,; the growth of labor productivity has stagnated; real wages are not increasing; and more and more people are getting frustrated and are feeling left out.
But, the problem is not just a national one. Globalization in both trade and finance make these problems become international. Furthermore, the speed at which money and goods move around the world is hard to believe, yet it is a reality of today’s world.
We saw, during the Great Recession, the role that national central banks had to play in providing liquidity to other central banks…and nations…in order to prevent the world recession from becoming worse than it was. The ability to transfer funds almost anywhere become breath taking.
And, this global financial facility continued to flourish once the Great Recession ended. We saw during the post-Great Recession period, the last nine years or so, the incredible flow of “risk averse” funds move to “safe haven” countries all over the world, The financial dislocations in Europe in 2010 and 2011, the problems in the South of Europe, the Greek crisis, to name just a few, saw massive amounts of funds move all over the world.
Mr. Powell does not mention the international pressures now being faced by the larger central banks of the world, nor does he talk about what the Federal Reserve faces in this instance. In this respect, I have written in View from the Peak, that the Federal Reserve System of the United States has, de facto, become the central bank of the world .
Joachim Fels, managing director and global economic advisor at Pimco in Newport Beach, California, writes in the Financial Times that “the Fed is not only the US central bank, but also the pacemaker for the global credit cycle.”
Consequently, Mr. Fels argues that the Fed cannot really act without taking into consideration Turkey and the Lira, the European Union and the Euro, the emerging nations, and, China and How It Manages the Renminbi.
The Federal Reserve cannot divorce itself from all else that is going on in the world. And, there is no economic model for this.
Mr. Powell and others at the Federal Reserve must review lots and lots of data. Analysis will be more along microeconomic lines rather than macroeconomic. Furthermore, they cannot rely on equilibrium models of the world economy to guide their decision-making process. Policy makers, at least for the near-term, are going to have to be pragmatists, nudging policy along, feeling for the right path, and backing off when they sense that “backing off” is what is needed.
This is a different world than the one most of us have worked in. Like our leaders and policy makers, we are going to have to learn how to work in this new world and it won’t be easy.