Central bank policy is center stage this week as the world turns its attention to Jackson Hole, Wyoming. The symposium hosted by the Kansas City Fed has become the prime venue for discussing monetary policy.
Federal Reserve Chairwoman Janet Yellen is set to deliver her speech on Friday, which will capture the attention of global markets.
Leading up to the event, Fed officials have been especially vocal and particularly unaligned. The rhetoric has caused more than a few Fed watchers to use the term “schizophrenic.”
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As UBS’s Art Cashin put it, “Fed types do not just contradict each other, now they contradict themselves.” This comment is in reference to a paper recently released by San Francisco Fed President John Williams.
Days after making the case that the economy is improving, and raising rates soon is justified, Mr. Williams put out a paper arguing that central banks need to “rethink” their monetary policy tools. His suggestions included increasing the inflation target (which they haven’t been able to meet in years), or scrapping it completely in favor of other targets based on price levels or economic growth.
The crux of his argument is that the natural rate of interest, which he calls r* (r-star) has declined over the past quarter-century to historically low levels.
The natural rate of interest, as Mr. Williams defines it, is the “interest rate that balances monetary policy so that it is neither accommodative nor contractionary in terms of growth and inflation.” He goes on to note that r-star is a function of the economy that is beyond any central bank’s influence.
While this seems more like a theoretical construct than anything else, economists have been trying to estimate r-star for many years.
This chart shows the estimated inflation-adjusted “natural” rate of interest for four major economies over the last few decades.
Mr. Williams’ point is that if the equilibrium interest rate that is neither expansionary nor contractionary is falling, it means that interest rates in general, will remain lower than we’ve been accustomed to in the past.
In terms of implications, he notes that conventional monetary policy will then have less room to stimulate the economy during a downturn. The result of this being longer and deeper recessions and slower recoveries.
It seems we’ve already gotten a taste of this, and the idea of a lower natural rate of interest is not new. The theory of secular stagnation put forth by Larry Summers hints at a similar outcome, ultimately stemming from persistently low growth.
Mr. Williams goes on to urge central banks and governments to consider fiscal and other policies aimed at raising the natural rate of interest. He believes raising the inflation target, or switching to a price level or nominal GDP targeting framework could accomplish this.
But this brings up an important question. Regardless of what the central bank is targeting, whether it be higher inflation or more growth, what tactics still remain available? In this environment, changing the central banks’ targets would still leave it in the same position, struggling to boost both inflation and growth.
Perhaps that’s why Mr. Williams’ paper focuses just as much on fiscal policy as it does on monetary policy. Reading between the lines, it’s clear that Mr. Williams believes monetary policy may be close to reaching its limits.
He hints at more reliance on unconventional monetary policy tools, such as central bank balance sheets, forward guidance, and negative rates. But even these are showing signs of decreasing returns. The ECB is having trouble finding bonds to buy and is quite literally buying anything that meets its requirements, while the Bank of Japan continues to buy up not just bonds, but equities too.
In short of a world where central banks own and prop up a vast majority of the world’s markets, what other tools are available?
I think that’s really the question at hand, and it’s likely the reason that this year’s theme at the Jackson Hole summit is “Designing Resilient Monetary Policy Frameworks for the Future.”
It will be interesting to see what ideas come out of the symposium, but one thing seems clear: we’re moving further into a new era of central banking which could see drastic changes ahead. The Fed’s traditional targets and methods may no longer be effective, and we, as investors, must be prepared to adapt to a new and unfamiliar environment.
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