The Growing Conundrum Facing Central Bankers
WHY YOU SHOULD CARE
If the Fed chief and global counterparts can’t predict the economy, we’re all in trouble.
By Rob Garver
President Trump relieved the financial markets of considerable uncertainty — and no small amount of anxiety — when he bypassed several conservative ideologues and nominated Jerome Powell to replace Janet Yellen as chair of the Federal Reserve Board in November.
But while the choice of Powell, a former investment banker who has served on the Fed’s Board of Governors for more than five years, may have allayed short-term uncertainty in the markets, it can’t resolve a deeper confusion rising inside the Fed, and the world of economics more broadly.
Powell, who is expected to be confirmed by the Senate, takes the helm of the Fed at a time when central bankers around the world are coming to terms with an unpleasant truth: The models that they have used to predict economic performance, and particularly the rate of inflation, don’t seem to work anymore. Unlike some central banks, the Fed has a so-called “dual mandate” — a statutory requirement that it manage interest rates with an eye to both maximizing employment and ensuring price stability. Historically, that hasn’t been a problem, explains Paul Ashworth, chief economist covering North America for the firm Capital Economics.
Those goals [of the Fed] are normally consistent, if you think about it — but now there’s a conundrum.
Paul Ashworth, economist
However, there’s growing evidence that the relationship between unemployment and inflation, which guided the Fed’s approach to its twin tasks, may have broken down. And it’s coming not just from the U.S. but from a range of other major economies, including Germany and Japan, and from institutions ranging from the Fed to the European Central Bank.
“Those goals [of the Fed] are normally consistent, if you think about it — but now there’s a conundrum,” says Ashworth. “The unemployment rate is unusually low, which suggests we should be raising interest rates, but the inflation data is still below the target.”
For decades, economists have followed a model that projects that a drop in unemployment will push up wages, leading to higher inflation, which central bankers can manage by raising interest rates. Known as the Phillips Curve, this empirical model that describes an inverse relationship between unemployment and inflation was developed in the late 1950s by economist William Phillips. Generations of central bankers have also relied on the model more generally as a largely dependable framework for understanding broad movements in the economy.
Emerging evidence is forcing a rethink. In the U.S., unemployment is near historic lows, but inflation has remained stubbornly below the 2 percent rate that the Fed considers optimal. Similarly, unemployment rates in other major advanced economies, such as Germany and Japan, remain low with no sign of inflation on the horizon. Last July, the European Central Bank was forced to revise its inflation predictions downward, and its president, Mario Draghi, said in a press conference that the changes in the relationship between unemployment and inflation were “profound.” In September, speaking to the Economic Club of New York, Fed Governor Lael Brainard said members of the Federal Open Market Committee (FOMC), the Fed’s interest-rate-targeting body, could see “no single highly reliable measure” of long-run inflation. And later that month, in a press conference following a meeting of the FOMC, Fed Chair Yellen referred to the apparent new relationship between unemployment and inflation as “mysterious.”
Some bankers, like Draghi, remain confident that the breakdown in the unemployment-inflation relationship is temporary. In July, he articulated hope that “we will go back to a relationship like we had before the crisis.”
But other economists, like Scott Sumner, the director of the Program on Monetary Policy at George Mason University’s Mercatus Center, believe the relationship was a mirage to start with. The old model is, and always has been, wrong, he says. It’s just that nobody cared all that much. “I think they’ve always been wrong, but here’s the thing: In past years, this kind of inflation undershoot — or sometimes it will overshoot — wouldn’t have been regarded as a big deal because the issues facing the economy were different,” he says.
The uncertainty over whether the disintegration in this relationship is temporary or permanent is important to resolve for central bankers around the world as they plan for the future, says Ashworth. In developed countries like the U.S., where interest rates are still within hailing distance of zero, central bankers don’t have much room to cut rates if the economy suddenly sours. “They need to know whether this is just a delay, and lower unemployment will lead to stronger wage growth and price inflation, or whether this is a structural change because of globalization or technological advances,” he says.
The weight of evidence suggests that central bankers might need to come up with a “new way of forecasting inflation,” says Ashworth.
Sumner believes the Fed should essentially surrender the job of predicting future inflation rates to the markets. Bond prices and other signals that indicate where investors expect inflation rates to be at a given point in the future, Sumner says, have done a better job of forecasting than the Fed and its models, especially in recent years. Others argue for taking even the market’s judgment of the future out of the equation by requiring the Fed to move target interest rates in prescribed amounts in tandem with measured economic indicators, such as inflation or GDP rate.
With the U.S. headed into what will almost certainly be another contentious election year, any major hiccups in the country’s economic performance will be met with sharp questions from campaigning politicians about the Fed’s strategy for the future. And it may take more than just Powell’s experienced hand at the wheel to find the answers.
- Rob GarverContact Rob Garver