This year’s Kansas City Fed Jackson Hole symposium is aptly titled as "Designing Resilient Monetary Policy Frameworks for the Future". What we need to know is the narrative, which story we are part of - not the relatively mundane question of whether the next Fed hike will be in September or December.
We are probably at or around the Goldilocks level of interest rates right now. The Fed could hike once but beyond that, they need to do a Rip Van Winkle and go into hibernation for a while.
A rate of interest is a rate of exchange between savers and spenders. It is the price at which supply of excess funds meets demand for excess funds. It is also the hurdle rate that must be overcome for risky ventures to pay off.
For a whole host of factors – the relative importance of which can be debated –something fundamental, something structural and secular has happened to the equilibrium rate of interest.
Academic literature refers to it as R* or the neutral rate of interest at which growth and employment can coast on a steady path accompanied by a steady, positive rate of inflation. Historically, that target rate of inflation has been set at the magic number of 2%.
Inflation in turn depends on the extent of spare capacity in the economy and the domestic price of foreign-sourced goods (oil or other imports).
As recently as mid-2012 (the time of the London Olympics), we used to think that an unemployment rate of 6% and a neutral rate of 4.25% is normal and consistent with a recurring inflation rate of 2%. And we used to think that for such a large domestic economy as the United States, the external sector did not matter – the value of the dollar or what is happening to bond prices elsewhere were not significant factors.
Cut to the Rio Olympics of 2016 and we are at a cross-roads.
If the job of official authorities is to subtract from – and not add to – the stock of uncertainty out there, the Fed has failed in recent years.
Having successfully tapered QE in late 2014 (following a delay since the ‘tantrum’ of May 2013), the Fed continued to issue forward guidance (visually in the form of dot-plots) that defied credibility. It was suggested that, with the US economy attaining escape velocity and with tailwinds such as declining oil prices (an effective tax cut), US monetary policy could diverge from the rest of the world.
So what if the dollar strengthened considerably (1 Euro bought just $1.10 versus the $1.35 that it could buy twelve months earlier) ? So what if QE was intensified in Europe and Japan (and China) and so what if there were 22 rate cuts in the rest of the world just in Q1 2015?
The dot-plots projected four hikes for last year. When we didn’t see the expected uptick in spending (consumers or corporate), wages and prices, we initially blamed the weather (it was apparently too cold to shop in the US, though not in Canada!) and latterly, on blowback from global factors. Helpfully, China contributed some drama in August 2015.
In the event, we saw one hike in December and since then, we’ve been waiting for the next one. Meanwhile, the dot-plots kept on suggesting four hikes for 2016.
All the while, we explicitly dismissed Larry Summers and his secular stagnation thesis while grudgingly bringing it back through the back door: we now acknowledge that dis-inflationary forces (driven by prolonged deleveraging, bank regulation, tech, demography, inequality – choose your pick) are relevant and the normal habitat of rates is lower than what it used to be.
So today, what I’m looking for from the Fed is whether they have finally drunk the kool-aid. In my mind, the kool-aid is as follows:
1. In order to achieve and sustain inflation of 2%, we need to allow inflation to overshoot first. It’s like parallel parking. Some, like my wife, can wedge car into position in one go. I, on the other hand, need to reverse in, then move forward before I straighten the car.
2. There is no way to know what R* is until after the fact. So, we need to take a risk with whatever estimate we go with. The balance of risks favors that we bias our estimates to the low side: why not assume that it is around current levels and leave it there for the foreseeable future?
3. Continue to stay data-dependent but rather than get antsy about every little piece of data (which can flip-flop upon revision) or even trying to be too clever with ‘nowcasts’, why not update information in true Bayesian manner and have a deliberately slow reaction function?
Go on, commit to falling behind the curve and communicate to the world that that is what you will do.
Remove the spotlight from yourselves and push the dialogue towards the other factors at play – fiscal, infrastructure, skills – stuff that are outside the scope of monetary policy. Monetary policy was the protagonist of the crisis management movie. It was also a primetime show when crisis measures had to be withdrawn with the precision of a bomb disposal squad. But now we’re no longer in crisis territory. Sub-1% rates are not crisis-level rates any more. They are the new normal. Until the fundamental conditions change, monetary policy needs to become a sideshow.
So for Jackson Hole 2016: I’m looking for credible signs of a change in mindset, a change in the framework with which we look at the world. In that framework, I would like to see a departure from the traditional Taylor rule to a multi-factor model that incorporates structural variables.
And I’d like to see a utility function that underweights the fear of falling behind the curve.
That would result in a one-off rally in stocks, a steepening of the yield curve and a modest sell-off in the dollar. After that, we’ll be on our own. With no further input from the Fed, we might actually have to do the hard labour of following the real economy.
Unfortunately, what I expect to see is a two-handed economist that will touch on the full suite of factors but keep its options open with regard to the relative importance of those factors. The Fed will remain a net contributor to uncertainty and instability in this part of the cycle.