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Policy Matters

Jackson Hole: Is the Fed at a Crossroads?

John L. Bellows, PhD
Portfolio Manager/Research Analyst

Executive Summary

  • Recent statements by Fed members have been confusing, with some members expressing near-term optimism and others expressing caution about the medium- and longer-term outlook.
  • The medium- and longer-term outlook is concerning, due to downside risks for inflation, disappointing productivity growth and limits to monetary policy. We expect Janet Yellen to focus on these medium- and longer-term concerns in her speech this Friday.
  • The conditions for the Fed to hike rates again—above-trend growth, improved financial conditions, and rising inflation expectations—have not been met, which is another reason why Yellen is likely to avoid the question of the timing of the next hike and focus instead on the bigger picture considerations.

A set of conflicting comments by Federal Reserve (Fed) members in the run up to Fed Chair Janet Yellen’s speech this Friday has raised questions about the direction of US monetary policy both through the end of the year and beyond. On the one hand, New York Fed President Bill Dudley said that, in his estimation, the bond market is underpricing the chances of the Fed raising rates at least once by the end of this year. On the other hand, both the minutes of the July Fed meeting and San Francisco Fed President John Williams raised the possibility of growth and inflation remaining low for the foreseeable future, which in turn would cause monetary policymakers to explore new and creative ways to ease policy.

Part of the difference between the two sets of comments can be attributed to differences in the relevant time frame: Dudley seems to be referring to raising rates in the near term, while the Fed minutes and Williams are referring to more medium- or even long-term considerations. Probably more importantly, however, some of the difference between the two comments can be attributed to the difference between expressing an outlook for growth in the second half of the year (the Fed is optimistic) and expressing a broader set of concerns about the asymmetry of the risks to the outlook and the efficacy of monetary policy (the Fed is worried about both downside risks and the limited efficacy of policy at the zero lower bound).

Western Asset’s outlook is that near-term growth is unlikely to be strong enough to justify a Fed rate hike. Real GDP has averaged only 1.25% over the last few quarters, falling well short of the pace needed to absorb the remaining slack in resource markets and put upward pressure on prices. As the Firm’s senior economist Mike Bazdarich has laid out in a recent installment of By the Numbers, the ongoing weakness in manufacturing and business investment, which has been a primary contributor to the disappointing results, has not shown any sign of abating.

Regarding the medium term, we share the Fed’s concerns about the downside risks to its inflation and growth outlook, and about the efficacy of monetary policy at these low levels of interest rates. We think these concerns will take on an increasingly central role in Fed communications, potentially including at Fed Chair Yellen’s speech this week at Jackson Hole. The next three sections of this note describe the underlying source of these concerns over the medium-term, while the final section concludes with more specific thoughts on possibilities for Yellen’s speech.

Inflation Outlook: Downside Risks

The behavior of inflation expectations this year quite clearly makes the case that although the prospects for inflation over the coming months may have brightened slightly, the medium-term risks to inflation remain to the downside. The case for a slight move up in realized inflation rests on a falling US dollar (the trade-weighted USD is 4% lower than its peak in January) and rising energy prices (WTI prices are $15 higher than the lows in January). Indeed, even stability in the US dollar and oil prices would be positive for realized inflation, as the sharp moves from early 2015 will eventually roll out of the year-over-year calculation. Yet, even with these positive developments and a slight move higher in core inflation, medium-term inflation expectations have actually moved lower this year. This divergence is evident in Exhibit 1.

Exhibit 1
Apparent Divergence Between Actual and Expected Inflation
Source: Federal Reserve, Bureau of Labor Statistics. As of 20 Jul 16.

Among the reasons for the ever-lower inflation expectations, we highlight two as particularly important. First, the global inflation outlook remains quite subdued. Developed markets are struggling to generate positive inflation due to either significant slack in resource markets (Europe) or due to sluggish demand and high savings rates (Japan). For their part, emerging markets still have a large amount of excess capacity (China) or are still recovering from the significant correction in commodity prices (Mexico and Brazil). The only countries experiencing higher than expected inflation over the past few years have been those that had large currency depreciations, but this type of “pass-through” inflation is neither desirable nor sustainable. The second reason we identify as key to ever-lower inflation expectations is that wage growth in the US has failed to move up, even as the unemployment rate has fallen below 5%. The failure of wages to move up faster is somewhat of a puzzle, closely related to trends in productivity and also the sustained downward pressure on labor compensation for US workers due to competition from foreign workers, a shift from manufacturing jobs to retail jobs, and rising inequality.

Of course many of these dynamics are well known, even if not completely understood, and the Fed has discussed both the global challenges and the risks to US wages on a number of different occasions. Nevertheless, it would be a mistake to minimize the extent to which low inflation expectations over the medium term is giving the Fed pause. The evolution of Yellen’s own statements on inflation expectations make the point clearly. In the third quarter of 2015, when market-based inflation expectations were slightly below 2%, Yellen said “On balance, the evidence suggests that inflation expectations are in fact well anchored at present.” Then in the first quarter of this year market-based inflation expectations fell below 1.5% and Yellen remarked that, “Unfortunately, the stability of longer-run inflation expectations cannot be taken for granted.” And finally, after further declines in the second quarter, Yellen concluded that inflation expectations had “moved enough to get my close attention.” That’s quite a change over less than a year, and suggests that the medium-term risks to inflation remain a first order issue for the Fed.

Growth Outlook: Productivity and Capital Expenditure

Productivity has become an increasingly central topic for market participants, largely because the extent of the disappointment in realized productivity has been so surprising. Even while the labor market has added 200,000 jobs per month for the past five years, GDP has averaged a tepid 2.0%, leaving productivity growth at a very low 0.5%. To put this in perspective, from 1950 to 2000 the average of productivity growth was 2%, and from 2000 to 2005 it was an even faster 3%. Low productivity matters not only because it’s an important component of the long-term outlook, but also because it is a primary driver of real wage gains and gains in standard of living (or lack thereof).

An important contributor to the low productivity growth has been weak business investment and Capital Expenditure (CapEx). Exhibit 2 puts the weakness in perspective. For most of the last 50 years, corporate capital formation (roughly equal to CapEx and represented by the light blue line) have run ahead of corporate savings (roughly equal to free cash flow and represented by the gray line), which has meant that non-financial corporations were net users of capital (represented by the blue bars). This has changed since the crisis, however, and for the past five years corporations have had savings in excess of capital formation, making them net suppliers of capital. As is evident from Exhibit 2, this is first and foremost due to sluggish capital formation, which has in turn weighed on productivity growth.

Exhibit 2
Capital Formation and Savings Patterns of US Non-Financial Corporations
Source: BEA. As of 31 Dec 15.

Lower productivity growth due to weakness in CapEx has two fairly straightforward implications for monetary policy. First, lower productivity growth means that, in general, the level of interest rates needed to keep the economy in equilibrium is lower than it otherwise would be.1 Second, it calls into question the outlook for continued expansion, as a pullback in corporate investment could presage a slowdown in hiring, which in turn could threaten consumption and the broader foundations of the recovery. (Note: this not our central outlook, but instead is one of the downside risks concerning the Fed). Both of these implications are dovish in the sense that they argue for a more cautious outlook and lower interest rates in the medium term.

Policy Outlook: Asymmetric Risks to Monetary Policy

The final consideration around the medium term is whether monetary policy can adequately respond to future shocks. On this question the Fed seems to have reached a consensus: monetary policy can adequately respond to upside surprises in growth or inflation, but monetary policy would be challenged to respond adequately to downside surprises. In this sense, there are “asymmetric risks” to monetary policy. The reason for this asymmetry is that, should the growth or inflation need an additional boost, the zero lower bound constrains the policy response and would make it difficult to provide more accommodation. There is no such constraint should growth or inflation need to be restrained, as the Fed can always raise rates.

In a March speech Yellen drew the following conclusion in her discussion about asymmetric risks:

“Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric.”2

In short, the constraints placed on monetary policy by the zero lower bound make the Fed more worried about downside surprises, which in turn makes the Fed more cautious in how it proceeds from here. In this sense, the considerations around the future for monetary policy (including how policy would respond to a surprise) suggest the Fed should maintain a more accommodative posture than it otherwise would if it were unconstrained.

What to expect from Janet Yellen’s Speech

The recent crosscurrents in Fed communications can be grouped into expressions of optimism about the near-term outlook and expressions of concern about the longer-term risks to the outlook and risks to monetary policy. Dudley’s observation that the market is priced below his expectations for the near term is fundamentally a statement about his optimistic outlook for an acceleration in growth over the next few quarters, and therefore an example of the former. The Fed minutes and Williams’ call for reexamining monetary policy in a world of low interest rates are based on concerns about the outlook and risks over the next few years, and therefore an example of the latter.

Where on this spectrum will Yellen be in her Jackson Hole speech? Of course it’s possible for her to express both perspectives—optimism about the next few quarters and caution over the longer term. Even if that were to be the case, we expect that the longer-term considerations will take precedent and be the thrust of Yellen’s message. Forecasting GDP growth has proven very difficult in the current environment, and the Fed’s forecasts have struggled along with everyone else’s. It would be uncharacteristic of Yellen to put an undue amount of weight on something that is so inherently uncertain. In contrast, the previous arguments regarding risks to inflation and growth, and also the risks to monetary policy, appear to have a more robust foundation and emerging consensus. For example, who can argue with the statement that monetary policy is harder and likely less effective at the zero lower bound? In addition, these longer-term issues seem more in keeping with the spirit of the Jackson Hole conference, which is usually an opportunity for reflection and big picture ideas. This year’s conference is titled “Designing Resilient Monetary Policy Frameworks for the Future,” suggesting it will be in keeping with that tradition. Finally, while Yellen’s job requires her to successfully navigate the quarter-by-quarter volatility, it’s the longer-term issues that will define her legacy, and accordingly we suspect that is where her focus will be this week.

By focusing her speech on medium and longer-term issues at the Jackson Hole conference, Yellen will likely refrain from sending a concrete signal about the timing of the next rate hike. Indeed, as Western Asset’s CIO Ken Leech discussed in his recent commentary, the prospects for the next rate hike remain very uncertain. The three conditions the Fed needs to justify a hike—above trend growth, improved financial conditions, and rising inflation expectations—have not been met, providing Yellen yet another reason to keep her focus on something other than the prospects for the next hike.


  1. For a more detailed discussion of this relationship, see this recent blog post, "The Fed's shifting perspective on the economy and its implications for monetary policy", by Ben Bernanke.
  2. Janet Yellen, March 29, 2016.
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