Navigating in the Mist: Powell's Three Theoretical Challenges and Their Policy Implications

In the past year, the market's outlook on the US economy has made a 180-degree turn: the unanimous expectation has shifted from a "hard landing" to a "soft landing." But looking ahead, has the Federal Reserve really ended its rate hike cycle? How long does it take to go from a pause in rate hikes to a rate cut, and what are the conditions? These questions remain unanswered. Faced with these unknowns, this year's Jackson Hole Symposium chose "Global Economic Structural Transformation" as its theme. Powell mentioned three theoretical challenges and the uncertainties they bring to monetary policy practice in his keynote speech: the neutral interest rate, the lagged effects of monetary policy, and the steepening of the Phillips curve, which correspond to the above questions. Guojin Securities conducted an analysis in their report on September 3rd to explore the answers to these questions. 1. The Unobservability of the Neutral Interest Rate: Has the interest rate reached a "sufficiently restrictive" level? In theory, monetary policy only has a contractionary effect when the real interest rate is higher than the neutral interest rate, and the higher the real interest rate, the greater the contractionary effect. The practical question is: what is the neutral interest rate? At the Jackson Hole Symposium, Powell said, "We are committed to achieving and maintaining a sufficiently restrictive monetary policy stance to ensure that inflation moves down over time to our symmetric 2 percent objective." Zhao Wei from Guojin Securities pointed out: The current policy stance is restrictive, putting downward pressure on economic activity, employment, and inflation. However, the neutral interest rate is uncertain, so there is always uncertainty about the precise level of monetary policy constraints. The "neutral interest rate" is unobservable and can only be estimated using models. It is not clear whether the federal funds rate has really reached a "restrictive" level. The so-called "slightly restrictive" or "fully restrictive" level mentioned by FOMC members is a subjective concept. In addition, there are differences between the estimates in the Summary of Economic Projections and those of the Federal Reserve Banks. For example, as of mid-year, the New York Fed's two models (LW and HLW) estimated neutral interest rate levels of 1.2% and 0.6%, respectively, differing by a factor of 2. 2. The Uncertainty of the Lagged Effects of Monetary Policy: Has the contractionary effect been fully realized? The lagged effects (lags) of monetary tightening are also uncertain, meaning there is uncertainty in both the timing and effectiveness of the contraction in aggregate demand following a rate hike. Guojin Securities believes that the wide range of estimates for lagged effects suggests that there may still be significant further drag in transmission. As long as bank credit continues to contract, the US economy will struggle to enter a true new recovery cycle, and the need to guard against credit risks means that the "recession narrative" will not be ultimately refuted. 3. Steepening of the Phillips Curve: How Sensitive is the Labor Market to Inflation? The Phillips Curve is a classic framework for examining the relationship between the labor market and inflation. For a long time before the 1980s, there was a certain trade-off between the "slackness" of the labor market and inflation. This means that low unemployment and low inflation cannot coexist, in other words, sacrificing unemployment to fight inflation. In the post-pandemic era, the Phillips Curve has steepened once again. Taking the relationship between core PCE inflation and the unemployment rate as an example, the slope between the two has changed from -0.06 from 2008 to 2019 to -0.44. This means that for every 1 percentage point decrease in core PCE inflation, the unemployment rate may rise by more than 2 percentage points. Guojin Securities pointed out that in the short term, the path to inflation may still follow the direction with a smaller sacrifice rate. However, in the long run, if the unemployment rate continues to remain low, can the 2% inflation target be "maintained"? Overall, Guojin Securities pointed out: Faced with the three major uncertainties in theory, the Federal Reserve is continuously slowing down the pace and frequency of interest rate hikes, while at the same time, it is making the endpoint level of interest rate hikes more ambiguous in order to maintain a certain degree of flexibility. With the recent weakening of fundamental data, the Federal Reserve may continue to choose to wait and see at the September meeting (the market is pricing in a 12% probability of an interest rate hike in September), and there is still uncertainty about whether there will be an interest rate hike in November. In the absence of obvious exogenous shocks, the weakening of economic indicators such as employment, income, and consumption, which reflect the endogenous momentum of the U.S. economy, may not be easily reversed. Even if the pause in interest rate hikes is implemented later this year, the risk of inflation rebounding next year may delay the timing of the Federal Reserve's interest rate cuts, thereby increasing the fragility of the economy and finance. In addition, the disturbances from overseas should not be underestimated, especially considering the upcoming political events.