My Five Takeways from the Fed’s Jackson Hole Symposium (4 min read)

The annual Jackson Hole gathering of leading Fed officials, international central bankers, and academics, always provides  a snapshot of high profile thought on policy. And this year’s was no different. Below are my five key observations from the event:

 

1. Running Out of Room for Cuts and the Drop in r*

a.  Fed Chair Powell noted that the pre-2008 era was characterized by long expansions supported by better monetary policy inevitably lead[ing] to destabilizing financial excesses’. The current (post-crisis) era’s question is ‘how best to promote sustained prosperity in a world of slow global growth, low inflation, and low interest rates’.

b.  Powell noted that the real neutral rate, r*, has declined between two and three percentage points over the past two decades (see chart: ‘Real-Time Estimates of r* and u*’). Further drops in r* could warrant cuts in policy rates, but this means they will be getting close to hitting the zero lower bound.

c.  Various speakers, including Powell, cited demographics, the rise of Asia, the EM savings glut, legacy borrowing issues, slower productivity, uncertainty about the future, globalisation, technology, less sustainable cross-border capital flows, and more tail risk as the reason for the decline in r*.

Chart 1: Real-Time Estimates of r* and u*

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Source: Kansas Fed

2. Monetary Policy is Globalising

a.  A recurring question throughout the symposium was whether economies – even those as large economies as the US – can set monetary policy independent of the rest of the world. Most thought no; policy had to incorporate global factors.

b.  A central reason for this view was that all advanced economies have seen their neutral rates, r*, decline over the last 30 years, and much of this has been driven by a common global component rather than local factors (see the increasing size of the orange bars in the chart: ‘r* intl. trends matter as much as domestic stance’).

c.  Part of the decline, it was suggested, could be due to the aforementioned factors (Section 1), which have affected all countries simultaneously. But it could also be reversion to the mean (r* was notably high in the 1980s).

d.  A key finding appears to be that countries’ monetary policy has been driven as much by this global decline in r* as local developments in output gaps and inflation.

e.  This implies that it is harder for domestic policy to move the dial and so instead monetary policy needs to be more globally coordinated. Last year’s Fed divergence highlights the cost of doing otherwise.

Chart 2: r* International Trends Matter as Much as Domestic Stance

Monetary Policy Drivers: A Decomposition
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Source: Kansas Fed

3. The Fed is Struggling to Deal with Politics

a.  Powell noted that ‘fitting trade policy uncertainty into this framework is a new challenge.’ And he also suggested that there are ‘no recent precedents to guide any policy response to the current situation’.

b.  The Fed’s communication could be improved. Phrases such as ‘data dependent’, the Federal Reserve will ‘act as appropriate’, and the Federal Reserve will follow a ‘balanced approach’ may confuse the public.

c.  Adopting policy rules could protect the Fed from political interference.

d.  The Fed does appear to follow a policy rule, which, despite its constant reference to r*, is a function of actual policy rates and expected changes in inflation and unemployment – the so-called ‘first differences’ rule (see chart: ‘Policy rule prescriptions: MPR’).

Chart 3: Policy Rule Prescriptions: MPR

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Source: Kansas Fed

4. The Dollar Cycle is the Global Financial Cycle; the Dollar Needs to be Scaled Back

a.  Despite the US’s shrinking share of the global economy, the dollar is becoming increasingly central to the global financial system. It is often the favoured currency for invoicing (dominant currency pricing), and is the preferred currency in for financial assets (see charts ‘The US dollar continues to be…’ and ‘Share of domestic/foreign…’).

b.  This centralisation could be related to demand for the dominant safe asset (dollar assets), or balance sheet constraints of global financial intermediaries.

c.  The trend is showing up in dollar funding pressures and in the Treasury basis – that is, foreign investors are willing to pay a premium to hold safe US assets. The same is not true for euro or yen assets.

d.  The US monetary authorities are now in the unique position of managing the world’s supply of safe assets. This helps contribute to the dollar cycle becoming the global financial cycle. Fed tightening and dollar strength is associated with a shortage of assets and a widening in basis, which pressures foreign investor holdings.

e.  The implication is that the Fed needs to take account of this additional channel to the rest of world.

f.  BoE’s Mark Carney was even more pointed arguing for a shift away from the dollar as the dominant currency of the world: ‘The dollar’s influence on global financial conditions could similarly decline if a financial architecture developed around the new synthetic hegemonic currency (SHC) [like Facebook’s crypto currency Libra] and it displaced the dollar’s dominance…’

Chart 4: The US Dollar Continues to be as Important Today as it was During the Bretton Woods Era

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Source: Kansas Fed

Chart 5: Share of Domestic/ Foreign Investor's Portfolio of Corporate Bonds in Issuer's Currency

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Source: Kansas Fed

5. Two EM Orthodoxies Challenged

a.  EMs shouldn’t always hike rates if there is a Fed hiking-induced sell-off in the particular EM country. This is because a weaker currency could aid the local economy in the face of the global risk shock.

b.  Both the Bank of England’s Mark Carney and the IMF’s Chief Economist, Gita Gopinath, suggested there are circumstances that warrant the use of capital controls: notably, when the emerging country has shallow FX markets and faces a capital flow or debt shock.

Bottom line: The Fed is struggling with how to deal with politics and its unsure of what playbook to use. Meanwhile, it recognises that it cannot set policy independent of its impact on the rest of the world. It also fears the Japanisation of policy, which was mentioned everywhere except in name.

Bilal Hafeez is the Editor of Macro Hive and can be contacted here

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)

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