The Fed Walks the Tightrope Over the Economy

Two days of testimony and Q&A of Federal Reserve Chair Jerome Powell in front of Congress should be a reminder that trying to control monetary policy involves much more than asking when interest rates will come down.

The Fed’s position is a complicated one. It has dual mandates to “enable price stability and maximum sustainable employment,” as the Chicago Fed says. Price stability means keeping inflation at a 2% rate, not above or below, based on the Price Index for Personal Consumption Expenditures (PCE). Maximum sustainable employment is something that changes over time and “may not be measurable directly” because many nonmonetary factors affect jobs.

For example, in his formal testimony, Powell discussed the labor market and that “a broad set of indicators suggests that conditions have returned to about where they stood on the eve of the pandemic: strong, but not overheated.” The ratio of open jobs to workers is roughly 1.26, slightly above where it was in 2019. Nominal wage growth is down. Inflation has calmed. The result as Powell said, is that “the risks to achieving our employment and inflation goals are coming into better balance.”

But that still means more work ahead because better balance means “it’s not just about getting inflation down,” Powell said in answer to a question, as Barron’s reported. “The job is not done on inflation, we have more work to do there. But at the same time, we need to be mindful of where the labor market is.”

An important reason is the mandate for maximum sustainable employment. About 69% of GDP is consumer spending. That has to be broadly based because wealthier people can’t consume or spend enough to keep the economy on an even keel. If unemployment ramps up significantly, it could help push the economy into a recession. That might play into the view of analysts from Citi Research, who argued that the Fed would start a series of rate cuts, which might sound immediately attractive. But even now, there might not be room for enough cuts to stimulate the economy.

Additionally, the Fed seems highly disinclined to plunge into ultra-low interest rate strategies. “I think we probably won’t go back to that era between the global financial crisis and the pandemic, [when] rates were very low and inflation was very low,” Powell said. He further noted that because current monetary policy “is restrictive, but not intensely restrictive,” and that R-star, or the so-called neutral interest rate that enables full employment and maximum output with stable inflation, may have risen. That would likely mean ongoing higher interest rates and cost of financing.