At the Thomas Laubach Research Conference in Washington D.C. in May 2023, the current U.S. Federal Reserve Chairman Jerome Powell and former Chairman Bernake discussed how the economy is performing and their views on inflation at this time. Here are my notes from the conference, as well as my own commentary for additionaly context; let’s dive in.
Lessons from history
The talk starts with an anecdote related to former Fed Chairman Paul Volcker, who is known for tackling inflation during the 1970s and 1980s. Volcker's mother insisted on giving him the same allowance as his older siblings many years later, even though the “real purchasing power” had been eroded. This reportedly helped to shape Volcker's views on the economy.
In a similar vein, Powell starts with telling us a bit about his background. According to Powell, he studied politics at Princeton, before going on to work as a lawyer in the financial sector during the 1970s. He recalls from that time that “high inflation was a permanent part of the landscape” and the “costs for getting rid of it was too high."
During this period, inflation reached a peak of 14%, as the Nixon administration broke the link with gold in 1971, which caused a massive devaluation of the dollar. This was driven by huge deficits, partially caused by an increase in spending during the Vietnam War, which finished in 1975.
A lesson Powell learned from that era is “price stability is the foundation of a strong economy." Another lesson he learned is that its the “responsibility of the central bank to restore price stability” during periods of high inflation.
The erosion of pricing power can impact many businesses and especially individuals at the “margins of the economy," mostly those who are “living paycheck to paycheck," as this cohort spends almost all their income on “food, transport and housing."
Bernanke also shares a story his grandma told him about growing up during the Great Depression. She told him many of his family went to school without shoes, and when he asked why, she said because the shoe factory was closed. Now even as a young child Bernanke understood that this didn’t make any sense, as the demand was still there. However, the real issue was the economy wasn't working properly, and this sparked his fascination with the topic.
The Silicon Valley Bank crisis
Bernanke shares his brief overview of the Silicon Valley banking crisis. The bank had “assets which were subject to risk” and as interest rates rose, the value of its long term assets fell. The bank hoped to hedge this via its deposit franchise, but a bank run halted these efforts, driven by leaked information. The third stage was contagion, as people did bank runs on similar banks.
This ultimately affects “credit conditions” and the “real economy." However, he states this is very different”from the 2008 crisis. Apart from the obvious “size and scope” of the crisis, the underlying instruments were different. As opposed to sub prime mortgages, U.S. Treasurys can “always be valued." In addition, if the economy did decline, U.S. Treasurys tend to become more valuable.
Powell adds that the “banking system is strong and resilient” and “well posiitoned" in his view.
What tools does the Fed have?
The Fed has various tools to help achieve its macroeconomic objectives. This includes “liquidity, supervisory and regulatory tools."
Measures include injecting stimulus like we saw in 2020, buying U.S. Treasury bills, changing regulations and of course raising or lowering interest rates. Each tool can have “seperate objectives” but the effects are “not entirely independent."
Powell reiterates his goal of “sustainably achieving maximum employment and price stability," which all depend on a “stable financial system."
Both the economy and the financial system are “intertwined” and thus the tools are not completed separated.
An example of liquidity tools being used independently was during the Silicon Valley Bank crisis. Powell used his “discount window” and “bank term funding program” to make liquidity available to banks that might need them. This enabled the Fed to bolster the financial system, without needing to adjust its monetary policy tools such as interest rates.
Supply chain shocks
Powell believes it is difficult to forecast future supply chain shocks. A sequence of “negative supply chain shocks” followed the beginning of the pandemic. As investors its useful to know which stocks are more vulnerable to supply chain issues.
The impact of unemployment
Many large technology companies hired aggressively in late 2020 and into 2021, which caused "wage inflation" among high-paying tech jobs. However, by 2022 and into 2023, many of these companies announced job cuts, though the figures still remained higher than pre-pandemic levels.
Bernake states that the pandemic “scrambled the labor market” this made it harder to judge the true employment numbers. A solution has been to use alternative metrics such as the “vacancy to unemployment ratio."
From the end of 2018 to 2021, we had approximately 4% unemployment. In 2018, we had a “one to one vacancy to unemployment ratio." By 2021, this metric had risen to two to one.
Powell believes “labor market slack” may be a common factor influencing inflation moving forward, even though it hasn’t been historically. An example, he gives is inflation in non-housing services, where “labor costs are a high proportion of total costs."
The importance of communication
A key strategic tool to inform investors and the general public includes an efficient communication policy. This also helps to “align market expectations with the Feds own thinking” according to Bernake.
If businesses are expecting inflation, they may raise prices, which could cause real inflation. Also, if the stock market is expecting high inflation and it comes in lower, that could boost stock prices.
Will the Fed tighten rates further?
Powell stated that there is “uncertainty about the lagged effects from tightening so far." Thus, he plans to do an ongoing assessment of the data.
Inflation has continued to fall from 9.1% in June 2022 to 4.9% as of April 2023. Therefore it is clearly on a downard trend. However, Powell has learned from the lessons of Volcker with regards to not taking the pressure off too soon.
Final thoughts
Powell has one of the toughest jobs in the world. All eyes are on his moves with interest rates in order to manage inflation. He seems to be very calm and willing to stay the course until inflation is truely squashed. In the short term, this will be painful for investors. However, given inflation has continued to fall, it should benefit investors in the long term.
