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Aug 28, 2020, 9:05 AM GMT
#MonetaryPolicy

FED's Departure from Classic Economic Theory Ruffles Some Feathers

Yesterday, the highly anticipated speech of Jerome Powell at the Jackson Hole symposium unsurprisingly stirred a wave of reactions amongst economists, policymakers, investors, traders, and other market participants.

Most of the polemic following the conclusion of Mr Powell's speech was concentrated on his statements on inflation, signalling that the FED is likely to maintain near-negative interest rates for a long time before the US economy manages to recover from the impact of the coronavirus hit completely.

Powell ruffled some feathers amongst the proponents of classic economic theory by arguing that the correlation between inflation and job gains is no longer as concise as it once used to be.

Powell noted that the famous Phillips curve, which represents one of the cornerstones of modern economic theory, is flattening. Consequently, it becomes more difficult for central banks to weigh in on the impact of current economic developments when adjusting their monetary policies.

He argued that the US labour market grew markedly prior to the coronavirus-triggered slump. Even though the unemployment rate in the US was driven to a decades-long low, the inflation rate did not grow as a consequence. Instead, inflation remained below the FED's 2 per cent symmetric target rate.

The seemingly absent correlation between inflation and unemployment is worrying because it could lead to "an adverse cycle of lower inflation", which, in turn, would compel the FED to keep the Federal Funds Rate near zero indefinitely.

In such a scenario, the FED would not be able to lift the rates to stimulate economic expansion and further jobs and wage gains, which could prove detrimental for the broader economy in the longer term.

Powell went on to hint that due to the seemingly broken correlation of the Phillips curve, the Federal Reserve is now ready to use its full capacity of tools to stimulate maximum employment.

Where he departed from classic economic thought was his admission that the FED no longer needs to cut rates to stave off unwanted surges in inflation when the labour market is growing so strongly.

The market received these remarks as a strong indication that the era of low interest rates is here to stay for a long time. What Powell and his colleagues are essentially trying to achieve is two hit two birds with one stone – maintain the dovish monetary policy stance and hope for robust gains in job growth and inflation.

The market did not know how to react initially with the EURUSD seesawing as Powell was laying out his outlook. In the aftermath of his speech, the pair advanced towards the historic resistance level at 1.18800 before rebounding just below it.