Fed Chief Pats Self on Back as He Looks to Extend 'Hot Economy'

It's a Goldilocks economy. And, in a speech Tuesday, Federal Reserve Chairman Jerome Powell said that he and his recent predecessors are partly to thank.

The economy grew 4.2% in the second quarter, the fastest in four years. Unemployment is close to an 18-year low, and many analysts project it has further to fall.

Typically such a "hot economy" would bring rising inflation, Powell told the Boston audience, according to prepared remarks. Workers become harder to find, lifting wages, and in turn driving production costs higher. Eventually, businesses pass those costs along to consumers. At least, that's the way it's historically worked.

But in recent years, the pace of price increases has lingered at or below the Fed's 2% target, even as unemployment fell and the economy strengthened.

What's changed? According to Powell, central bankers have modified their policies for setting U.S. interest rates to focus on expectations of future inflation alongside direct recent price data.

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"Many factors, including better conduct of monetary policy over the past few decades, have greatly reduced, but not eliminated, the effects that tight labor markets have on inflation," Powell said in the speech.

For investors, the upshot is that Powell is convinced the Fed's plan to continue gradually raising interest rates to prevent inflation expectations from becoming "unanchored," is sound.

Last week, the Powell-led central bank raised interest rates for the third time this year, and the chairman said in a press conference that "this is a pretty good moment for the U.S. economy." Higher interest rates tend to tamp down inflation by making it more expensive for businesses and consumers to borrow money, thus acting as a brake on economic activity.

The Fed, which cut rates to near zero in the wake of the financial crisis a decade ago in a bid to stimulate the economy, has been raising them since late 2015 as growth recovered. Last week's increase brought them to a range between 2% and 2.25%, and Fed officials project that further hikes could push rates to 3.4% by 2020.

President Donald Trump's $1.5 trillion of December tax cuts have extended the economic recovery begun under his predecessor, Barack Obama, though at the expense of wider federal budget deficits that have rapidly ballooned the national debt past $21 trillion. 

With the economy running hot Fed officials have noted rising complaints of worker shortages - a potential sign that inflation could be close to a sudden increase. In his speech, Powell said the words "shortage" and "bottleneck" are appearing more frequently in regional surveys of business executives.

"Like us, many of you are hearing widespread anecdotes about labor shortages and increasing bottlenecks in production," Powell said. "Businesses now list 'quality of labor' as their most important problem, as opposed to the more typical report of 'poor sales.'"

"Like us, many of you are hearing widespread anecdotes about labor shortages and increasing bottlenecks in production," Powell said. "Businesses now list 'quality of labor' as their most important problem, as opposed to the more typical report of 'poor sales.'"

The central banker added in a separate Q&A with the audience that while so-called "fiscal policy" -- U.S. government spending and tax cuts that Trump and Congress rather than the Fed control -- are "providing real support for demand this year and probably for the next couple of year ... longer term, we're not on a sustainable fiscal path. This is the top of the cycle, and it's a good time to be working on putting our fiscal policy in order."

Still, Powell said that everything suggests that the Fed is doing the right thing for its part -- better, in fact, than central bankers of the past.

"Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times," the central banker said.

Of course, as Powell noted, the risk is that the Fed has got it completely wrong.

"We do not fully understand the causes and implications of these changes, which raises risk management issues," Powell said. 

Like Goldilocks, but when the bears come home.

(Boston correspondent Adam Smith contributed to this article.)

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