The Federal Reserve and Navigating by the Stars

Growth in the global economy remains healthy, with the United States and Europe – which bore the brunt of the crisis 10 years ago – sustaining the momentum. The U.S. is going through one of the longest periods of expansion in its history; Wall Street has hit record highs, with unemployment at its lowest levels in the last 30 years. Income per citizen in the European Union is growing at a rate similar to the United States, albeit with higher levels of unemployment.

Traditional macroeconomic policy dictates that in a scenario such as the above, a rise in interest rates should be in the cards. Raising interest rates, so the theory goes, helps slow inflation, dampens the euphoria in financial markets, and finally allows greater flexibility to manage the inevitable cyclical slowdown in income, investment and employment. Despite this, central bankers remain cautious. The reasons behind this were, in part, laid out frankly by Jerome Powell in his first speech as Federal Reserve chairman during the Federal Reserve Bank of Kansas City’s annual gathering of central bankers at Jackson Hole, in the mountains of Wyoming.

Powell used a nautical metaphor in his explanation. Central bankers have always navigated by the stars of inflation, unemployment and potential revenue and have been guided by the stars’ movement relative to each other. As far as possible, they try to steer a route through calm (or “neutral”) waters in which inflation remains steady and unemployment does not rise to undesirable levels. Powell said, however, that the stars are no longer in the same position that navigators have traditionally found them; establishing a new route means finding them again. To leave the metaphor behind, for years the lack of inflation has been a constant source of surprise, despite a labor market in which “almost everyone who wants a job can find one.”

The reasons behind prices holding firm in conditions that, in the past, would have rapidly pushed them upward, are still not clear. At Jackson Hole, it was suggested that these reasons might lie, above all, in structural changes to the economy. Princeton economist Alan Kreuger attributed the reasons to workers’ decreased contractual power, and Raghuram Rajan, of the University of Chicago, attributed the reasons to the concentration of “good salaries” in just a few sectors and companies. Others believe that official statistics underestimate the rise in productivity due to new technologies. In the absence of certainty around the exact position of the stars, the Fed, like many other central banks, is following the principle of common sense. In Powell’s words, “When you are uncertain about the effects of your actions, you should move conservatively.” His statement was greeted by a new Wall Street high. The course plotted so far of slow tax increases will be followed step by step with great care in order to avoid both the risk of unnecessarily halting the rise in income and that of “destabilizing excesses.”

The Fed chairman in effect reaffirmed the independence of the Fed in relation to a president who had tweeted that he expected greater support for his own policies. Powell restricted himself to the stars of economic theory, but there are other strong grounds for the uncertainty weighing on the choices of the Fed and other central banks. These grounds call for great caution. Political rather than economic factors threaten the steady growth of the global economy today. If Trump’s customs policy were to lead to a true trade war, prices to consumers would rise, and profits and growth in income would fall. The uncertainty is heightened by Recep Tayyip Erdogan’s challenge to rational economics, another possible period of instability in the European Union and the problematic management of Italian public debt.

Economic research has come a long way in the last 10 years due to, above all, the huge amount of data available on workers, consumers and companies. This access is promoted by central banks which use it in their decision making. The data help to decipher the new structure of the economy, but contrary to what some people believed before 2007, they are not enough to provide a “scientific” basis for monetary policy. This has proved true until now, and will continue to be the case for the foreseeable future. Just as they did in the uncertain years of the 1930s, central bankers practice an art and not a science; it is an art that produced the practice of “whatever it takes,” the symbolic description of an unorthodox, untested policy with which the financial crisis was managed.

Faced with a new emergency, Powell has also declared that he is ready to do “whatever it takes.” That should reassure us. At the same time, we should bear in mind that, given the fact that circumstances would inevitably be different, any action taken would once more be in response to a new and different set of events, and the result may not be so fortunate.