Jerome Powell to Markets: The Destination Matters, Not the Journey

It was also an incomplete message because Mr. Powell didn’t explain what will determine the terminal rate, leaving open the risk that the Fed will overdo it.

Going into this week’s meeting, markets were hoping for a sign that the Fed, after a fourth straight 0.75-percentage-point rate increase, might soon pivot to a slower tightening pace, and perhaps an outright pause. The Fed statement released at 2 p.m. Wednesday suggested it would: “In determining the pace of future increases…the [Fed] will take into account the cumulative tightening of monetary policy [and] the lags with which monetary policy affects economic activity and inflation.”

The resulting jump in stock prices and the fall in bond yields was short lived. Soon after Mr. Powell started his press conference at 2:30 p.m., he explained that even if rate increases slow, “we may ultimately move to higher levels than we thought at the September meeting.”

This makes tactical sense. Central banks adhere to the Brainard principle, named for the economist William Brainard, which says that if you’re unsure how changes in the short-term interest rate affect the economy, go slowly. Tightening in three-quarter percentage-point increments made sense when rates were plainly far too low—like taking big strides on familiar terrain. But the higher rates get, the less certain the impact becomes. Downshifting to quarter or half-point increments gives the Fed more time to assess that impact, just as small steps in an unfamiliar place makes a wrong turn less likely.

This also makes strategic sense because the ultimate impact of monetary policy on growth and inflation depends on the terminal rate, not the path to that rate. The evidence in the past few months suggests the terminal rate needs to be higher than the 4.6% Fed officials wrote down in September. Inflation as measured by the consumer-price index is still running above 8% annually, wage growth is running at 5%, and the prerequisites for both to ease—a weaker consumer and job market—haven’t materialized.

But what will determine that terminal rate? Outsiders typically try to explain the Fed’s behavior using a policy rule: the combination of economic, financial and inflation factors that determine the terminal rate. Thus far, though, the Powell Fed hasn’t really followed any discernible policy rule.

On Wednesday, Mr. Powell wasn’t any more helpful. He acknowledged nominal rates need to go above inflation (i.e., real rates must be positive). But that means the terminal rate depends on the inflation rate, which is surprisingly difficult to pin down: It depends on whether you use the past or future data, which price index, and which items, if any, are excluded. Mr. Powell declined to say, except that it wasn’t necessarily 5%, the 12-month change in the price index of personal consumption excluding food and energy. It also depends on other financial conditions, such as the added interest-rate spread businesses and households pay compared with the Fed’s target rate.

Mr. Powell emphasized, as the Fed has signaled since June, that he will err on the side of raising rates too much rather than too little, judging the latter to be the tougher error to repair. “Until we get inflation down, you’ll be hearing that from me,” he said.

Yet if the Fed really does wait for inflation to come down before pivoting, it’s at great risk of raising rates too much. Monetary policy works with lags because it takes some time for higher rates to slow economic activity and even more time for that slower activity to bring down inflation.

Some Fed officials have lately hinted that those lags loom larger in their thinking; so have some foreign central banks who raised rates less than expected. Mr. Powell gave little sign Wednesday he agrees—and thus the end of the Fed’s tightening cycle is still up in the air.

Write to Greg Ip at [email protected]