Because he was more of a regulator than economist, Governor Powell flew below many radar screens. All that changed when he became a clear contender to be the new head of the Federal Reserve, and we’ve had a lot of homework to catch-up on, reading speeches he has given over the last year or so to become acquainted with his macroeconomic outlook. On the rate front, he told us what we need to know last June in his remarks, then ignored now widely quoted, to the Economic Club in New York City: “The Committee has been patient in raising rates, and that patience has paid dividends.”

Just as importantly, it appears he is among those questioning why inflation is so low, which would also encourage a patient approach to normalizing interest rates.
Let’s start with his understanding of interest rates. The following excerpts are from a speech given on January 7. 2017:

There are also many factors other than monetary policy that are holding down long-term interest rates. Long-term nominal and real rates have been declining for over 30 years. The next slide decomposes long-term nominal yields into expected future short-term real rates, expected future inflation, and a term premium. These estimates are based on one of the Board’s workhorse term structure models. All three components have contributed to the downward trend in long-term nominal yields….
The downward trend in nominal term premiums likely reflects both lower inflation risk and the fact that, with inflation expectations anchored, nominal bonds have become an increasingly good hedge against market risk. That has made bonds a more attractive investment and reduced the term premium.4 As shown in the next slide, a regression of the 10-year term premium on measures of 10-year inflation expectations and a rolling beta of Treasury returns with respect to equity returns (to proxy for the hedging value of bonds) shows that these two factors can account for a large part of the decline in the term premium.

The accompanying slide puts this remark into perspective:

There is a large amount of research explaining why global interest rates are so low. Bernanke’s global savings glut theory,an idea that is still relevant, was the famous first attempt. Others (Brainard) argue that lowered inflation expectations support the decline. As for inflation–another component of the interest rate equation–there are a number of theories about why it is so low. These range from increased international competition to technology creating more price transparency. Finally, research by the San Francisco Fed also explains low rates using standard, economically accepted methodology.

Regardless of the underlying reason, Powell clearly understands there are fundamental reasons for low interest rates. They are not low because of some vast conspiracy. By signaling his acceptance of the underlying research, we can conclude there will be no fundamental change in the underlying market philosophy espoused by the Fed.

What about the pace of increases? Those are likely to be slow:

The healthy state of our economy and favorable outlook suggest that the FOMC should continue the process of normalizing monetary policy. The Committee has been patient in raising rates, and that patience has paid dividends. While the recent performance of the labor market might warrant a faster pace of tightening, inflation has been below target for five years and has moved up only slowly toward 2 percent, which argues for continued patience, especially if that progress slows or stalls. If the economy performs about as expected, I would view it as appropriate to continue to gradually raise rates. I would also see it as appropriate to begin the process of reducing the size of the balance sheet later this year. Of course, both decisions will depend on the performance of the economy.

Powell has noticed the weak pace of inflation increases, which was again highlighted in this week’s PCE release:

He has made no more recent comment on the topic, so we don’t know if his thinking has changed. But recent Minutes indicate the Fed is starting to look more deeply into the low inflation situation and may start to rethink their overall philosophy in this area.

The bond market is stodgy, need we add? It would react poorly to a radical change in Federal Reserve philosophy. Powell seems to be a solid, middle-of-the road candidate. While he doesn’t have academic economic training, all evidence is he has worked diligently to learn. Overall, it appears Powell will provide “steady-as-she-goes” leadership.

…

Saint Louis Fed President James Bullard has been speaking out a lot recently. He recently proposed a new interest rate regime that, instead of focusing on models, uses a very intuitive decision tree to determine if raising rates is appropriate. He gave a speech at the end of last week that asked three questions: would the US see GDP growth greater than 2% in the coming year, would inflation hit the Fed’s 2% inflation target and would wages increase as unemployment decreases. His answer to all three was, “Probably not.” And in a break from tradition, he relies on incoming data rather than models to support his conclusions.

Bullard first observes that U.S. growth since the end of the great recession has converged to 2%. The following graph illustrates his point:

Since the third quarter of 2009, the average Y/Y growth rate has been 2.1% while the median growth rate has been 2%. There is little reason to project anything but moderate growth in the third quarter. Industrial production and real retail sales have both slowed. The three-month average payroll job growth is 185,000 per month -a solid rate but not one that warrants robust growth projections. Real income excluding transfer payments continues to increase but at a slower rate. The New York Fed’s Nowcast for third quarter GDP growth is 1.46% while the Atlanta Fed is calling for 2.8% growth The average of these two projections is 2.1%, which happens to be the approximate average of the blue chip forecasting consensus. The preceding information supports Bullard’s argument that there is a low probability of anything but more moderate growth.

Bullard moves on to inflation, arguing that it is doubtful that inflation, as measured by the personal consumption expenditure price index, will broach the Feds 2% target. The following data supports his conclusion:

The BEA breaks PCE price data into three components: services, and durable and non-durable goods. Durable prices (in red, 10% of the index) have been subtracting from price pressures for the last 10 years. And their negative impact is pretty high: these prices have been contracting around 2% for the last year. Non-durable prices (in green, 20% of the index) are weak; they subtracted from inflation for all of 2015 and most of 2016, only recently adding any upward pressure. Their latest reading was for a 1.3% year-over-year rate of growth—hardly anything to be concerned about. That leaves services (in red, 70% of the index) to create all the upward pressure that the Fed needs for PCE inflation to hit 2%. Statistically, that’s very difficult to do.

Several Fed governors have advanced different theories to explain why inflation is so weak. Some have argued that global supply chains allow producers to purchase products from low-cost areas, keeping internal price pressures low. Others have argued that real-time access to price information allows consumers to buy at the lowest cost, which continually squeezes retailers’ margins. Another theory states that an aging population—such as that in Japan, the EU, and the United States—spends less, leading to lower demand, which translates into less demand-pull price pressures. Also consider that commodity prices are weak across the board, keeping input price pressures at bay. The real answer probably encompasses pieces of all these theories along with others that haven’t been considered yet. But regardless of the cause, it’s difficult to see why people continue to assert that inflation will return to 2% in the intermediate term. The data simply do not support that conclusion.

Bullard final point is that the Phillips curve is exceedingly flat. He offers the following table culled from academic research:

Clearly the unemployment rate/inflation rate relationship has weakened a lot. Minnesota Fed President Neel Kashkari, who was again the lone dissenter on June’s rate increase, offers the most logical explanation of this disengagement. To get around retirement issues and the like, he considers prime-age workers, and notes that their participation rate and employment/population ratio indicate there is more slack in the labor market than before the crash, and therefore there is room for improvement