Jay Powell’s dovishness is right, but not for the reasons he believes

To the surprise of many, Federal Reserve chair Jay Powell struck a decidedly dovish tone in his press conference on Wednesday. This came immediately following the issuance of the central bank’s periodic policy statement in which the wording on inflation was hardened by stating that “in recent months, there has been a lack of further progress towards the committee’s 2 per cent inflation objective”.

I suspect that Powell’s rather relaxed dismissal of sticky inflation will prove appropriate, but not in the way he expects. Economic developments are likely to show that the Fed is unable to get to 2 per cent unless it is willing to impose large and unnecessary damage on the economy. Indeed, 2 per cent may not be the right inflation target for an economy going through so many structural changes, both domestically and internationally.

By brushing aside three months of higher-than-expected price and labour cost inflation, Powell initially triggered a significant fall in interest rates and a sharp rise in stocks before a retracement. His dovishness is by no means precedent setting. Indeed, some of Powell’s press conference remarks in the past have been more dovish than the actual committee discussions on policy, as shown by the release of meeting minutes a few weeks later.

In contrast to his relatively strong characterisation of the economy, there is mounting evidence that the US economy is slowing. First-quarter GDP, the latest monthly ISM index on manufacturing activity and consumer sentiment measures all came below the consensus forecasts. Moreover, as noted this week by the Financial Times, an increasing number of companies are reporting that “poorer consumers in the US are cutting their spending in the face of persistent price rises”. Starting with limited financial and human resilience, they have experienced the sharpest drawdown in pandemic savings and a significant increase in debt. And now they could well see an increase in unemployment that would then spread weakness up the income ladder.

At the same time, sticky inflation is likely to prove more persistent than Powell expects, given ongoing, multi-year structural transitions that are inherently inflationary. Domestically, the US has been moving away from deregulation, liberalisation and fiscal prudence to tighter regulation, industrial policy and chronic fiscal looseness. Internationally, globalisation has been giving way to fragmentation, with systemically influential countries and a rising number of multinationals slowly but surely rewiring supply chains to put national security and resilience ahead of efficiency and immediate cost-effectiveness. 

Such factors do not appear to have prompted Powell’s dovishness, at least judging by his remarks. But his resistance to validating the more hawkish policy stance priced by markets is appropriate for this world of weakening growth dynamics and structurally sticky inflation. It would avoid the unnecessary damage that would be caused by weaker growth. This includes worsening inequality, greater resource misallocations and a higher risk of financial instability.

The biggest risk facing the US and the global economy came from elsewhere in Wednesday’s press conference. Asked about the level of inflation, Powell responded: “3 per cent cannot be in a sentence with satisfactory.” It would not surprise me that the appropriate inflation is closer to 3 per cent than the 2 per cent target, an arbitrary specification that originated in the early 1990s in New Zealand. Yet the internal trauma and external credibility damage caused by the Fed’s big 2021 policy mistake leads it to repeat at every meeting that the Fed “is strongly committed to returning inflation to its 2 per cent objective”.

What is at stake here goes beyond the US. A failure to recognise the implications of multi-year structural changes would complicate monetary policy management in much of the world. Emerging economies would find it hard to reduce interest rates as warranted by their domestic conditions, fearing that this would undermine their already depreciated currency in a disorderly way. Japan’s economic and financial normalisation would be hindered by a too-weak yen. And the European Central Bank, while correct in stating that it is not “Fed-dependent”, would find that there is a practical limit on how far it can diverge from the Fed.

For now, we should welcome Powell’s dovishness even though it’s not for the reasons he puts forward. We should also hope that, over time, he and his Fed colleagues will become more strategic in their approach to policy signalling and actions.