View Behind Powell’s Jackson Hole Speech

In the Jackson Hole speech last Friday, Fed Chairman Powell made reference to an important new study by several senior Fed staff economists.

The study tackles a common objection against the Fed’s “balanced approach” of putting substantial weight on both the deviation of inflation from the 2% target and the deviation of unemployment from the estimated natural rate. The objection is that the rate is imperfectly measured and might turn out to be considerably lower than the committee’s current estimate of 4.5%. Given this uncertainty, the reasoning goes, the Fed should overweight the observed inflation gap, which not only forms half of the mandate but might also provide more information about the amount of slack remaining.The study suggests that this would be an unwise choice. First, the fact that the Phillips curve is so flat means that backing out current slack from inflation is difficult. Second, the starting point for the economy is one of inflation near the target, unemployment below estimated nature rate , and growth above trend—a combination that lowers the cost of overestimating the rate and raises the cost of underestimating it. Taken together, these points suggest that the Fed should put at least as much weight on the estimated employment gap as in the “balanced approach” under current circumstances.

Unlike the bond market, we did not view Powell’s speech as dovish, partly because of its references to the Fed staff study. Our forecast remains another two hikes this year and four hikes in 2019, as we expect not only core inflation overshoot but also a sizable unemployment undershoot—and an FOMC that continues to care about that undershoot.