Along with all but confirming there will be an interest rate hike in September, Federal Reserve Chairman Jerome Powell’s remarks at the annual Jackson Hole Symposium emphasized several important uncertainties about the structural aspects in the U.S. economy that greatly complicate the central bankers’ medium-term job of setting monetary policy. Against these uncertainties, Powell cited what many economists call the “Brainard Principle” (after Yale economist William Brainard), which states that when you are uncertain about the effects of your actions, you should move conservatively.
But how conservatively should the Fed move?
Currently, consensus on the FOMC (Federal Open Market Committee) maintains that despite the cumulative seven rate hikes already announced in this cycle, the real fed funds rate is still supporting U.S. economic activity. The August FOMC statement retained the message that “the stance of monetary policy remains accommodative,” while strong growth, firming inflation and low unemployment suggest that the economy may not need the Fed’s support.
However, as the policy rate continues to rise and approach plausible estimates for where policy is no longer accommodative – which according to August FOMC minutes could be “fairly soon” – the direction of monetary policy becomes more uncertain. A simple reading of the Brainard Principle, coupled with the long lags needed for monetary policy to affect the real economy, suggests it may be appropriate to slow down the pace of hikes or perhaps even pause for a time to assess the economic impact of the tightening to date.
The FOMC must weigh this strategy against other factors, including the prospect that the historically low level of the unemployment rate could engender higher inflation or financial imbalances that require a recession to restrain. In his speech, Powell referenced a paper (“Some Implications of Uncertainty and Misperception for Monetary Policy”) recently published by Federal Reserve Board staff, which finds that despite uncertainty around estimates of structural aspects of the U.S. economy, including the unemployment gap (the level of labor market slack), central bankers should not ignore these estimates. Indeed, the authors find that a “notable response to the unemployment gap is typically beneficial, even if that gap is mismeasured.”
Given FOMC participants’ projections for a further decline in the unemployment rate to levels well below their estimates of neutral, the practical application of this paper is to gradually hike rates to a more restrictive stance. Time will tell whether the FOMC’s decisions more closely reflect this paper or the Brainard Principle.
The eternal balancing act
Powell’s speech underscored what we have referred to as the Fed’s medium-term policy dilemma of how to balance the risks of over-tightening with the risks of over-heating. Despite Powell’s caution around uncertain estimates of structural elements in the economy, we continue to believe that the New Neutral framework of low equilibrium policy rates will be a useful anchor for fixed income investors.
We are currently forecasting a total of four additional rate hikes between today and the end of 2019, which would bring the fed funds rate to a range of 2.75%–3%, near the top of PIMCO’s estimate of the neutral policy rate (2%–3%). And while it’s possible that the state of the economy could warrant interest rates overshooting our estimates of neutral, little evidence of U.S. financial market imbalances, together with well-behaved inflation, argue for a still-cautious approach.
For our detailed views on the interest rate outlook and its implications for investors, please see “Rise Above Rising Rates.”
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.