Federal Reserve Chairman Jerome Powell is in an unenviable position. Folks expect him to fine-tune interest rates to keep the economy going and inflation tame but he can’t make things much better — only worse.
Growth is nearly 3% and unemployment is at its lowest level since 1969. What inflation we have above the Fed target of 2% is driven largely by oil prices and those by forces beyond the influence of U.S. economic conditions — OPEC politics, U.S. sanctions on Iran, and dystopian political forces in Venezuela and a few other garden spots.
When the current turbulence in oil markets recedes, we are likely in for a period of headline inflation below 2%, just as those forces are now driving prices higher now.
Overall, long-term inflation has settled in at the Fed target of about 2%. The Fed should not obsess about it but keep a watchful eye.
Amid all this, Powell’s inflation compass has gone missing. The Phillips curve, as he puts it, may not be dead but just resting. To my thinking, it’s in a coma if it was ever alive at all.
That contraption is a shorthand equation sitting atop a pyramid of more fundamental behavioral relationships. Those include the supply and demand for domestic workers and in turn, an historically large contingent labor force of healthy prime-age adults sitting on the sidelines, the shifting skill requirements of a workplace transformed by artificial intelligence and robotics, import prices influenced by weak growth in Europe and China, and immigration.
Of course, Mariner Powell has his North Star — what economists affectionately call R* (R-Star), but it is no longer at a fixed position in Powell’s sky.
R* is the federal funds rate that neither encourages the economy to speed up or slow down. However, with businesses needing much less capital to get started or grow these days and for decades China and Germany—the second and fourth largest economies globally—racking up current account surpluses and savings to invest abroad, it is no wonder the forces of supply and demand have been driving R* down to historically low levels.
With long-run inflation at 2%, current estimates put the nominal R* at a bit below 3%. That’s just three more quarter-point rate increases away.
Overshooting could kill the recovery but how is Powell to know?
Miner Powell’s canary has gone AWOL. Historically, economists and financial types have looked to the yield curve for the warning croak that the economy is headed for recession.
When I wrote about a flattening yield curve on MarketWatch early last December, the 10-year TMUBMUSD10Y, -0.27% less 30-day Treasurys TMUBMUSD01M, -0.13% spread was about 120 basis points. Now it’s about 100, and folks are even more nervous.
Although the gap is supposed to tell us about investor expectations for growth—a wide spread meaning optimism and a narrowing gap the threat of recession — these days, long rates are significantly affected by factors quite beyond the U.S. economy.
Increasingly, the dollar BUXX, -0.26% is the currency of payment for import contracts — 40% of imports worldwide are invoiced in dollars even though the United States is only about one-tenth of the market. And populist movements in Europe and political uncertainty elsewhere have driven private-asset managers and savers into dollars. Consequently, foreign private actors — not just foreign central banks — have a ravenous appetite for Treasurys and dollar-denominated deposits.
The economists at the Fed are really econometricians bent on estimating all these relationships with ever-more-complex statistical techniques but they only have historical data. The parameters keep shifting, and historical information can only inadequately tell us their values.
All the Fed can do is feel its way with an eye toward price pressure in the core. In the 1950s, we hit unemployment below 3%, and it could go much lower than 3.7% without much inflation.
We have strong reason to believe the equilibrium short-term rate is no more than 3% — though on that Chairman Powell is agnostic. And if we take Federal Open Market Committee policy statements and the plot chart at face value, Powell and his colleagues intend to drive the federal funds rate to well above that by 2020.
That’s dangerous stuff.
