Jackson Hole review: Fed looks to lessons from the past

Fed leans on historical outcomes for future guidance

Nick Frappell
Global General Manager

Key points:

Reasons not to tighten, Part I
Reasons not to tighten Part II…with context
What if inflation really did take off?
The global dis-inflation thesis

‘It’s not clear to me that we’re really doing anything useful here.’

James Bullard, President of the Federal Reserve Bank of St. Louis, 10th August 2021

Purpose of today’s update:

To condense some points over the Federal Reserve’s monetary policy post-Jackson Hole, bring context, and hopefully raise interest levels in one or two arcane talking points…

The Jackson Hole Symposium

The Jackson Hole symposium — sponsored by the Kansas City Fed — has gained more prominence as the Federal Reserve showcases policy developments such as the ‘Flexible Average Inflation Target’ or ‘FAIT’ which hit the headlines in 2020.

[Ed note: FAIT allows the Fed to run above its mandated inflation target to compensate for regularly running below it, in the hope that this would shift inflation expectations a little higher ‘on average’ and enable the Fed to reach its longer run ‘2 %’ level.]

Arguably Jackson Hole has gained more importance, as since the implementation of FAIT, the Fed has discarded forward guidance and market participants look for clues elsewhere.

As the US economy showed strong signs of recovery earlier in 2021, and fiscal spending surged as a result of the government response to Covid, and is likely to grow even more under the Biden Presidency, the crucial issue of when monetary policy would normalise became even more prominent, especially as:

Asset markets such as housing and stocks continue to rise.
Inflation data heats up.
There is a growing discussion around the equity or inequity of Fed policy as it relates to the ‘real’ economy and different income groups.

Pre-Symposium

Post strong jobs data, with the US economy adding around 800,000 jobs a month over the prior three months, hawkish comments from Fed Vice-Chair Richard Clarida, and Boston Fed President Eric Rosengren signalled that it’s an appropriate time to scale back the Fed’s policy of buying US$120 billion per month of securities, which is broken down into US$80 billion of Treasury notes and US$40 billion of agency MBS (Mortgage-Backed Securities).

St. Louis Fed President James Bullard and Boston’s Eric Rosengren will join the FOMC in 2022, with Dallas Fed President Robert Kaplan joining the Alternate Members of the FOMC in ‘22.

Clarida: ‘The economy is likely to meet the criteria for tightening by late 2022.’ (Earlier than Fed forecasts.)
Bullard: ‘Sketched an aggressive timeline for tapering, which he thinks should start soon and concluded as early as next spring [2022]’.
Rosengren: ‘Tapering appropriate to start in the fall…October or November. Tightening would depend on the labor market.’
Kaplan: ‘Would like to see tapering start in September…businesses are weathering Delta variant in a more resilient manner.’

Not only do the Fed Presidents see scope for tapering sooner rather than later, but some also see considerable risks to the economy from mis-priced assets and that ‘The purchases of [US] Treasuries and agency mortgage-backed securities were no longer the right remedy in an environment of severe shortages of essential materials and workers.’ (Rosengren)

Clearly, since the US housing market is far from broken, having risen 18.60 % year-on-year (Case-Shiller National index) there is a question mark over the logic of buying US$40 billion a month of mortgage-backed securities, a hangover from a run on the mortgage-backed asset market at the height of the GFC.

The Chair’s response

Fed Chair Jerome Powell took a cautious route, responding last Saturday that ‘clear progress’ had been made towards maximum employment and that the Fed’s test of ‘substantial further progress’ had been made towards the price stability goal. The goal of tapering asset purchases within this year is appropriate if the economy ‘evolves broadly as anticipated’.

However, conditions were not yet in place to assume a lockstep increase in rates post-tapering, and it is this element of Powell’s speech which is essentially dovish. The difference arises from the contrast between reducing an accommodative policy, which is what tapering does and actual monetary tightening.

Even when tapering is complete, and prior to an explicit rise in the Fed Funds rate, there is still an accommodative element to Fed policy, because the Fed’s substantial holdings of US Treasury and Agency MBS* act to drive medium term interest rates lower than they might otherwise be.

Reasons not to tighten, Part I

The US labour market is far from ‘maximum employment’ and contains a fair amount of slack. Additionally — despite some notable inflation data recently — it is not clear that inflation is on track ‘to moderately exceed’ 2%, the Fed’s anchor point around which ‘Flexible Average Inflation Targeting’ can orbit.

Reasons not to tighten Part II…with context

Jerome Powell’s speech at Jackson Hole contained more nuanced and historic references.

As the labour market appears foremost in Fed thinking, the Fed are keen to avoid policy errors from the past, where the Fed tightened too early in an effort to moderate inflation, notably in the 1950s. With monetary policy lagging by around a year, and evidence to suggest that much of the recent inflation data should ‘drop out’ by then (as base effects on the index fall away), it would be easy to tighten too early. This matters for the labour market in particular because the Fed is conscious of the scope for long-term damage to the economy from extended unemployment and underutilisation in the labour market. There is plenty of evidence to show long-term scarring to workers, the productive capacity of the economy and the resultant threat to real wages.

The risk of overreacting is even higher when policy rates hover close to the ‘Zero Lower Bound’, as they clearly are.

Inflation was acknowledged as running up sharply with economic re-opening, however the following points were noted:

Absence of broad-based inflation pressures
The spike appears to be related to goods and services related to the pandemic and re-opening.
Moderating inflation in higher-inflation items
Moderation as shortages ease and some items go into reverse (used-car prices, for example).
Wages increasing in line with the Fed’s inflation target, which suggests that inflation expectations are well-anchored.
Broad-based measures don’t alarm; lower-skilled jobs are seeing a rise in wages.
Global dis-inflationary forces remain in play.
Or are they?

What if inflation really did take off?

Powell’s speech made it clear that the Fed has the tools to deal with that. And they do. However, the unspoken question was of course, what effect would be using those tools to counter a clear and ‘non transitory’ inflation spike have on asset markets where valuations look stretched to even the most bullish observers, and where global debt has soared post GFC, to an incredible US$281 trillion by February 2021. (IIF/Bloomberg)

This may have been the counterpoint in IMF Chief Economist Gita Gopinath’s comments (published on Monday 30th August 2021) that emerging economies cannot afford a ‘taper tantrum’ – or a rapid normalisation of US monetary policy in response to higher-than-expected inflation, quite apart from a ‘tantrum’.

The global dis-inflation thesis

The dis-inflation thesis points to the steady decline in the prices of durable goods, referenced by Jerome Powell in his presentation, the long-term decline in the neutral rate of interest (described as the ‘the interest rate that supports the economy at full employment/maximum output while keeping inflation constant’. It cannot be observed directly, but it can be modelled), and demographics. All these have served to pull inflation and interest rates lower over time.

Source: (left) Bloomberg; ABC Refinery (right) The World Bank; OECD
[Ed note: To model the neutral rate of interest, see p. 33 of how I calculate this. Weise, C.L, & Barbera, R. J. ‘Minsky meets Wicksell: using the Wicksellian model to understand the 21st century business cycle.]

The belief that the post-pandemic world will look broadly similar to the pre-pandemic one informs this part of Powell’s speech. Threats to this include a slowdown in offshoring, reductions in the share of world trade and assumptions about the impact of demography on inflation. The composition of emerging economies and their output of durable goods versus services may also prove to matter.

On the right I show the growth in the Chinese labour force over the last 40 years and the rapid integration of China into the global trading system. It is the combination of the two, not just the sizeable growth in additional labour, that is deflationary.

The long term decline in the price of durable goods (left) as referenced in Powell’s speech.

Source: (left) US Bureau of Economic Analysis (right) ILO; UNCTAD; ABC Refinery

How are markets viewing inflation?

Markets are viewing inflation fairly benignly. Despite pressure on certain businessses and commodity prices, the bond market views that inflationary forces are containable, and may hold clues that a policy errror is likely to damage longer term growth, or that longer term growth prospects are fairly tame.

Source: Bloomberg; ABC Refinery

Is the film just like the book?

It may not be. However, it is for the period that matters for the speech.

For the longer term, work by the BIS suggests that the next 40 years will see a reversal of the deflationary impact of demographics, which will change the narrative for the next generation quite profoundly in terms of the demographic impact on inflation.

Fed focus on labour data

Thank you for persevering. Fed Chair Powell has placed labour markets and employment at the centre of his thinking on Fed policy. Though the Fed has made sure their consideration of the threat of inflation is signalled, in detail, both to show financial markets and the wider world that it is receiving due attention and managing inflation expectations properly is key — knowing that said expectations were allowed to run out of control in the 1970s with a harder landing being engineered as a consequence.

Discordant voices

However, the broad brush and cautious approach adopted in Powell’s Jackson Hole speech could run into heavy opposition if data continues to show growth and rising prices. Seven out of 18 policymakers indicated that they want tightening to begin in 2022, according to the June ‘Dot Plots’. That number could grow as growth does and expose some serious cracks underneath the new approach to ‘Flexible’ targeting.

The soothing sounds of a summary…

The case for transitory inflation was well made with the distinction between tapering and tightening laid out to hopefully allay bond market nervousness. In some ways what was a cautious (and disappointing?) speech, still spelt out that normality is returning and that the roadmap towards a shrinking balance sheet and reduced assistance from the Fed was drawn out.

The speed at which we travel on that road will most likely be governed by the effects of a virus that will be very unresponsive to decisions made by Chair Powell and his fellow Board of Governors.

Regards,

Nick Frappell
Global General Manager

For ABC Refinery

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*An agency MBS is a Mortgage-backed security issued by one of three quasi-governmental agencies. These are the Government National Mortgager Association (GNMA) The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation, variously nick-named, Ginnie Mae, Fannie Mae and Freddie Mac.

Bibliography

Powell, J. - ‘Monetary Policy in the Time of Covid’, Jackson Hole, 27th August 2021
Juselius, M. Takáts, E. - ‘The enduring link between demography and inflation’, BIS Working Papers No 722, May 2018
Weise, C.L, & Barbera, R. J. - ‘Minsky meets Wicksell: using the Wicksellian model to understand the 21st century business cycle’,
Gopinath, G. - Financial Times, 30th August 2021.
Nicita, A. & Razo, C. - ‘China: the rise of a trade titan’, UNCTAD,
Majid, N. - ‘The great employment transformation in China’, ILO International Labour Office, Employment Working Paper No. 195 & others