Federal Reserve chief Jerome Powell might speak softly, but he wielded a big stick on Friday in challenging how central banks traditionally go about raising interest rates.
In his first major speech at the annual summer retreat for central bankers in Wyoming, Powell laid out his case for a gradualist approach to raising rates despite telltale signs of budding U.S. inflation such as low unemployment, rising labor costs and higher prices for raw materials.
Read: Fed’s Powell downplays risk of overheating, still expects gradual rate-hike pace
Powell contends that traditional signals such as low unemployment are no longer very accurate in signaling when inflation is going to rise and endanger the economy. He even said the level of inflation itself might not be the best indicator of whether trouble lies ahead.
As evidence, Powell pointed to the last two recessions in 2007-2009 and 2000-2001 as stemming from excesses in financial markets rather than in higher inflation.
Since the central bank’s lodestars in forecasting inflation are less accurate, Powell said, the Fed has to look at a broader range of signals before acting.
The Fed “has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to shifting navigational guides,” he said.
Given the circumstances, Powell said it’s best the central bank err on the side of caution. While he made it clear the Fed will continue to raise rates, he said the Fed should move conservatively.
“In other words, when unsure of the potency of a medicine, start with a somewhat smaller dose,” Powell said.
So far that’s what the Fed has done, slowly lifting a key short-term U.S. interest rate from near zero at the end 2015 to the current level of 1.75% to 2%. The Fed is also expected to raise rates a quarter-point in September.
Stocks edged higher following the highly anticipated speech, with the S&P 500 SPX, +0.57% and Nasdaq Composite COMP, +0.82% pushing back into record territory, while Dow industrials DJIA, +0.50% gained around 150 points, or 0.6%. Treasurys rose, pulling down yields TMUBMUSD10Y, -0.42% , and the dollar extended a decline versus major rivals.
Powell’s speech at Jackson Hole was a coming out of sorts, reflecting his long career on Wall Street as an senior executive whose job was to manage investment risks. He lacks an economics degree and speaks in a more down-to-earth manner than the typically stilted language of longtime central bankers.
In his speech Powell referred to risk management several times, reinforcing the need for the Fed to think differently about the economy.
“Risk management becomes the new Fed mantra at Jackson Hole,” wrote chief U.S. economist Gregory Daco of Oxford Economics.
Powell praised the “let’s wait one more meeting” policy of former Fed Chairman Alan Greenspan, for instance, in keeping rates low during the ”new economy” boom of the 1990s when conventional wisdom suggested much higher rates.
Then as now, Powell noted, inflation remained surprisingly low even as the economy surged.
“Given what the economy has shown us over the past 15 years, the need for the sort of risk-management approach that originated in the new-economy era is clearer than ever before,” Powell said. “Risk management suggests looking beyond inflation for signs of excesses.”
The approach laid out by Powell could sound a death knell for the so-called Taylor rule that has been used in the past to help the central bank determine when to raise rates. Powell said there’s “no single, simple approach” or “explicit recipe or rule” that should guide the Fed’s decisions.
“Powell is not worrying about whether inflation is coming or not coming or whether unemployment is too high or too low,” said chief U.S. economist Steve Blitz at TS Lombard. “He’s worries about whether money is too cheap or too expensive” for borrowers on Wall Street and Main Street.
In other words, he’s looking at risk like the former investment manager that he was instead of a central banker.
The big question is whether Powell is right—and whether the rest of a Fed staffed by career or longtime central bankers will follow suit. Fed careerists have adopted steadily more nuanced views of monetary policy over time, but the central bank is still prone to get jumpy when inflation starts to rise.
Powell noted that even when Greenspan was at the height of his powers in the 1990s he still needed to deliver a healthy dose of persuasion to fellow board members and Wall Street investors.
“In retrospect, it may seem odd that it took great fortitude to defend ‘let’s wait one more meeting,’ even though inflation was low and falling,” Powell said.
Richard Moody, chief economist at Regions Financial, said Powell’s skepticism of inflation forecasts is likely to keep the Fed on a gradualist path. But he thinks the Fed chairman may still face “a hard sell” in persuading colleagues if inflation edges any higher.
Are there any situations in which the Fed should throw caution to the wind?
Powell named two. When inflation soars or sinks unexpectedly or when the economy erupts in a crisis like the financial panic of 2008. In effect, Powell, effectively sanctioned the radical steps taken by ex-Fed boss Ben Bernanke to stabilize the economy after the panic.
“‘We will do whatever it takes’ will likely be more effective than ‘we will take cautious steps toward doing whatever it takes,’ ” Powell concluded.
