Alan Greenspan, who was the chairperson of the US Federal Reserve from 1987 to 2006, had once remarked: “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.” Thankfully, the current lot of central bank governors and chairpersons talk in a straightforward manner. Fed chairperson Jerome Powell is no exception to this. Powell’s latest speech at the economic policy symposium held at Jackson Hole, Wyoming, was 1,301 words long—with the word inflation being mentioned 46 times—leaving no doubt as to what the focus was on.
The US, like much of the western world, has been battling very high inflation. In a period of 12 months ending June, inflation as measured by the personal consumption expenditures (PCE) price index, excluding food and energy items, stood at 4.1%.
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From December to May, this core PCE inflation was largely in the range of 4.6-4.7%, significantly higher than the Fed’s target of 2%.
Even at 4.1% in June, core inflation is much higher than the targeted 2%. Also, as Powell put it: “A single month’s improvement falls far short of what… [we] need to see before we are confident that inflation is moving down.” The implication being that the Fed isn’t done with fighting inflation as yet and interest rates will remain high for a while. Or as Powell said, “Restoring price stability will take some time.”
Further, one school of thought believes that the current bout of high inflation is largely on account of constrained supply in the aftermath of the pandemic. While that’s true, there is a strong demand element as well. In order to dampen the negative economic impact of the pandemic, the US government handed out money directly into the hands of people. This, along with multiple investment bubbles, made people feel rich and that led to an increase in consumer demand, thus fuelling inflation. So, Powell rightly believes that the Fed’s job is to moderate “demand to better align with supply”. And this can only be achieved by maintaining high interest rates.
Also, longer the current high inflation lasts, the greater the chance of high inflationary expectations becoming entrenched, thus keeping future inflation high. If inflation stays high for a while, people start believing that inflation will remain high even longer and start incorporating this thinking in their wage and pricing decisions. As Paul Volcker who was Fed chairperson from 1979 to 1987 once put it: “Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.”
Of course, high interest rates come with their own share of costs. As Powell points out in his speech: “Reducing inflation is likely to require a sustained period of below-trend growth.” Clearly, unlike many other central bank governors, Powell does not seem to believe in sugar coating his message. Simply put, higher interest rates dampen demand, which in turn slows down inflation, but the dampening of demand slows down growth as well.
The financial markets seem to have taken the Fed’s thinking in their stride, having already discounted for what Powell was likely to say, given that his message at Jackson Hole wasn’t really any different from what he has been regularly saying in the monetary policy press conferences. The yield on the 10-year US treasury bond has gradually gone up over the last three months. On 25 August, it stood at 4.23%, up by around 60 basis points from June. The Dow Jones Industrial Average, America’s premier stock market index, rose by around 0.7% on Friday.