At the 25-27 August Jackson Hole Symposium, US Federal Reserve Chair Yellen broke little new ground – beyond confirming that the case for a US rate rise had strengthened – and suggested the policy-setting Federal Open Market Committee was generally satisfied with its strategy for interest-rate normalization, the available monetary policy tools to combat future recessions and the overall policy framework. We find this message somewhat disheartening.

Given the FOMC’s limited space to cut short-term rates, a persistently low equilibrium policy rate and the likely challenges of relying on asset purchases and forward guidance, we had hoped to see some evidence of greater openness to change. Overall, we are left with a sense of ‘business as usual’. If this is indeed the case, it implies a Fed that may be unprepared to counter another recession aggressively should potential growth and equilibrium policy rates remain depressed.

What messages did we glean from Yellen‘s remarks?  What can we say about the overall approach to policy normalization, the policy toolkit for supporting growth and inflation in different states of the business cycle, and considerations for the longer-term policy framework?

A US rate rise this year is highly likely

Data has evolved since the surprisingly weak May payrolls report in a manner that is consistent with the Committee’s expectation for moderate growth, the continued strengthening in the labor market and the gradual firming of inflation. In light of this, Yellen believes that “the case for an increase in the federal funds rate has strengthened in recent months.” We had already assigned a 75% probability to a rate increase this year, so Yellen’s remarks were not particularly surprising.

Still, the decision to address the near-term policy outlook at a conference focused on longer-term policy considerations suggests that the Committee has grown more confident in the economy’s performance and is marginally concerned by somewhat complacent market pricing of the path of policy rates. We still see December (45%) as the somewhat more likely timing than September (40%) for a rate increase given below-objective core inflation and the risk management considerations discussed below, but we will revisit these probabilities after the August payrolls report. Another strong number (225 000 private-sector jobs) in combination with firming wages and a decline in the unemployment rate could suffice to tip us into the September camp, though we would caution that the next policy meeting is not until 20-21 September.

Neutral policy rate still targeted when core PCE inflation hits 2%

Overall, we find this disappointing. As discussed in a previous note, we see compelling reasons for the Committee to hold off on raising rates at least until there is more convincing evidence of inflation moving towards mandate-consistent levels. As the July PCE inflation data confirmed, this is just not the case at present (see Exhibit 1).

Exhibit 1: Personal Consumption Expenditures (PCE) excluding food and energy, the Fed’s preferred gauge of US inflation, remains well below the central bank’s two percent (January 2012 – June 2016)

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The reasons include constrained policy options at the lower bound, growth risks that are still tilted to the downside, low inflation expectations and uncertainty about the current and future level of the equilibrium policy rate. In practice, the Committee will likely tolerate inflation rising somewhat above two percent. But policy-setting could achieve better outcomes if the current strategy explicitly allowed for (or even sought) inflation above two percent over the medium term, which would reinforce that the Committee treats the inflation objective symmetrically.

Absent such a shift, investors are likely to continue to expect inflation to run below two percent on average over the coming years. Two percent inflation will continue to be viewed as a policy ceiling, implying an actual inflation objective somewhat below this level.

Peak policy rate: perhaps only be about 150bp away

Judging from the Fed’s June Summary of Economic Projections, the Committee on average sees the longer-run policy rate at three percent, or one percent in real terms. However, both in her June press conference and again at Jackson Hole, Yellen suggested that the equilibrium real policy rate might not rise above its current level near zero for many years. Specifically, she noted at Jackson Hole that “the average level of the nominal federal funds rate down the road might turn out to be only two percent”.  If this is indeed the case, we are likely to see a continued flattening of the Committee’s median projected interest-rate path in future projections.

Asset purchases and forward guidance are no longer unconventional

With a persistently low equilibrium policy rate and the continued aversion to taking the policy rate into negative territory, the FOMC will have limited scope to ease policy through rate cuts even if it succeeds in raising rates all the way back to a neutral policy setting (from a loose policy now) before the next recession. Asset purchases (possibly including a wider range of financial market instruments) and forward guidance will remain the primary policy tools. One implication is that right-sizing the Fed’s balance sheet – returning to a situation in which the Fed’s assets largely align with currency in circulation – is unlikely to occur for well over a decade.

Cautious optimism on the efficacy of asset purchases and forward guidance

Overall, Yellen struck a tone of optimism on the ability of the Fed to provide future economic stimulus largely through asset purchases and forward guidance, even noting that simulations of various policy options show that these tools can provide better outcomes for employment and inflation than cutting the policy rate deeply into negative territory.

Still, she noted a number of reasons for caution in relying on these tools – model simulations may overstate the effectiveness of asset purchases and forward guidance when rates are already low; these tools may need to be taken to extremes to be fully effective; and such use may increase financial stability risks.

Cautious rate normalization and eventual tolerance of an inflation overshoot

Yellen’s note of caution on relying on asset purchases and forward guidance to fight future recessions has implications for current policy normalization. Even if the Committee’s strategy has not changed, in practice the FOMC will be very careful to avoid unduly restrictive policy-setting to lower the possibility of having to revert to asset purchases and forward guidance.

Any weakening of key economic indicators, tightening of financial conditions or heightened risks to global growth will likely lead the Committee to delay policy normalization, as has been the case for much of this year. If the downside risks rise meaningfully, the Committee will likely remove its tightening bias – and possibly begin cutting rates – more quickly than it traditionally has.

All of this implies that the Committee will be more tolerant of inflation overshoots. Should global disinflationary pressures wane, the ‘new normal’ could be one in which inflation averages above two percent, even if growth hovers around trend.

The longer-run policy framework is unlikely to change

Two weeks ago, President Williams of the Federal Reserve Bank of San Francisco created quite a stir by suggesting possible changes to the FOMC’s policy framework including  a higher inflation target and price-level or nominal GDP targeting. Yellen acknowledged these ideas as ‘important subjects for research’, but emphasized the Committee is not actively considering such changes. Thus absent a recession, we see little scope for a meaningful rethink of the policy framework.

We find this disappointing, to say the least. In an environment where the policy rate is still close to the effective lower bound and the neutral rate remains significantly depressed by historical standards, the Committee has a responsibility from a risk management perspective to carefully examine possible changes to their operating framework that could deliver better outcomes for growth and inflation when the next recession inevitably hits.

Column by BNP Paribas Investment Partners written by Steve Friedman.