Powell Takes the Brakes Off Inflation, Dumping Taylor Rule

The Federal Reserve sent markets into rally mode early Thursday with its announcement that it will let inflation creep upward as it monitors the economy. 

Screenshot of Federal Reserve Chairman Jerome Powell videoconferencing into the Jackson Hole Symposium on Thursday. The provost of the University of Michigan, Susan Collins, is pictured left. (Image via Courthouse News)

MANHATTAN (CN) — Markets rose on news of the Federal Reserve changing its approach toward inflation and employment, as investors largely ignored poor GDP and unemployment data.

By the closing bell, the Dow Jones Industrial Average gained 160 points, a 0.5% increase and 78 points above where it began the year. The S&P 500 also increased but shed many of its morning gains, netting just 0.17% for the day, while the Nasdaq fell 0.3%. 

Markets were spurred into positive gains early in the day after the Federal Reserve announced fundamental shifts to how it approaches inflation. Chairman Jerome Powell said during the annual Jackson Hole Symposium that the central bank was willing to allow unemployment to dip lower and that it wants inflation to increase.

The move gave markets an early lift, as it indicated that interest rates would likely remain low for years to come.  

In the statement, the Federal Reserve noted it would focus on “shortfalls of employment from its maximum level” rather than “deviations from its maximum level.” The effect is that the central bank might not raise interest rates if unemployment dips to lower levels.

Further, the Fed will continue its longer-run goal of 2% inflation and will use “appropriate monetary policy” during periods when inflation runs below that 2% threshold. 

“The persistent undershoot of inflation from our 2% longer-run objective is a cause for concern,” Powell said, hinting that deflation — in which the overall prices of goods falls — is now a possibility. 

“Many find it counterintuitive that the Fed would want to push up inflation,” Powell continued. “However, inflation that is persistently too low can pose serious risks to the economy. Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.”

Powell noted that if inflation expectations fall below 2%, interest rates could also continue to decline. “In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates,” Powell warned. “We want to do what we can to prevent such a dynamic from happening here.”

The federal funds rate is already at a historically low 0% to 0.25% rate, and the Fed under Powell has consistently rebuked calls to move into negative interest rates as Japan or parts of Europe have in the past. 

Powell noted he has no interest in tying inflation to any particular employment rate, however, as the ceiling for employment is often changed by non-monetary factors.

After the speech, the Dow Jones Industrial Average gained about 200 points, coming closer to its previous high point of 29,551 points back in February. The S&P 500 and Nasdaq had lesser gains but were both still pointing up for the day. 

The reaction among analysts was mild surprise, as Powell has been seen as extremely cautious with interest rates during the economic downturn.

“This largely just codifies the extremely dovish policy strategy the Fed has already been following,” wrote Kathy Bostjancic, an economist with Oxford Economics. “This formal adoption along with Powell’s still-cautious economic outlook underscore that the Fed will keep rates near zero for a long time.”

Others were less sanguine with the move, noting the Fed’s break with the long-term theory, called the Taylor Rule, that the central bank should lower interest rates when inflation is below a certain target level. 

“The ‘rules’ versus ‘discretion’ debate is now over,” tweeted Tim Duy, an economics professor at the University of Oregon. “Discretion wins as Powell throws the Taylor Rule into the dumpster.”

Others shook their heads at Powell’s concern for inflation remaining under 2%. “Concern? This at a time when unemployment is above 10% and many that are working are living paycheck to paycheck,” wrote Peter Boockvar, chief investment officer at Bleakley Advisory Group. 

Unemployment numbers that came in at expected levels did not move the needle much for markets. About 1 million additional new claims were filed during the week ending August 21, the Labor Department said Thursday. Last week, about 27 million Americans received jobless benefits, including the 10.9 million workers filing claims under the Pandemic Unemployment Assistance program. 

In the United States today, the unemployment rate is 9.9%.

The other news of the day was the final GDP estimate for the second quarter of the year, which showed GDP tanking at a highest-ever 31.7% rate. Though far greater than the 5% drop felt during the first quarter, the decrease was also largely expected by analysts since previous estimates had pegged the decline at 33%. 

When combined with the first quarter, the contraction is the third greatest in U.S. history, behind the World War II demobilization and the Great Depression. A correspondingly huge expansion in GDP is expected for the third quarter. 

The Bureau of Economic Analysis cautioned that “the full economic effects of the Covid-19 pandemic cannot be quantified in the GDP estimate for the second quarter of 2020 because the impacts are generally embedded in source data and cannot be separately identified.”

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