Why Even Central Bankers Are Unsure What to Do Now
The 50-million-year-old Grand Tetons, which formed the majestic backdrop for last week's annual meeting of central bankers in Jackson Hole, Wy., are still rising.
But the bedrock of monetary policy for the past decade, the so-called Jackson Hole Consensus, is crumbling.
What was obvious at this year’s meeting was that monetary policy experts are not certain how to conduct policy now that interest rates are near zero.
What was less obvious is that there are big differences among them in how to run the world’s central banks once things return to “normal” —whatever and whenever that may be.
In his much-anticipated speech on Friday, Federal Reserve Chairman Ben Bernanke made entirely clear the uncertainty surrounding current policy. After saying in no uncertain terms that the Fed stood ready to “strongly resist” deflation by, among other things, purchasing more Treasurys, he acknowledged that the Fed itself “has not agreed on specific criteria or triggers” for further action.
Why? The reason, Bernanke said, is because the Fed hasn’t figured out how to calibrate those actions. “Uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.”
Translation: The Fed has not agreed how much of a decline in the economy is sufficient to bring the central bank into play, and it does not know how much of an effect a given quantity of purchases will have.
Markets and Fed observers had an intuitive feel for this calibration mechanism when interest rates were positive. A given increase in the unemployment rate would suggest a decrease in the Fed’s overnight lending rate of a quarter or a half a point.
That is anything but clear as we head into Friday’s jobs report. The consensus calls for a decline of 100,000 jobs, with the the private sector expected to create 42,000 jobs. What if, for example, private-sector job levels instead fall by 100,000? Is that enough to cause the Fed to increase the size of its balance sheet (the trigger)?
Let’s say it is. By how much should the Fed increase its balance sheet for that amount of decline (the calibration)? Are the increments of treasury purchases in $50 billion units, or $100 billion units?
Having given the market the promise that the Fed would act, Bernanke has yet to detail a framework for policy. The confusion showed up Monday when Michelle Girard, senior economist from RBS , said on CNBC that she believed the current 9.5 percent unemployment rate is already unacceptable to the Fed and could prompt additional quantitative easing (QE), or printing money. (For the record, she echoed one side of the Jackson Hole debate that held additional QE won’t do any good. The counter that was that if the Fed came in and bought a whole lot more Treasuries it would definitely bring down yields.)
In the same segment, Bob Doll, chief equity strategist for Blackrock, said he thought conditions would have to deteriorate significantly to prompt the Fed to act. Neither Girard nor Doll had much of a clue over the possible increments for action.
Bernanke’s speech doesn’t help much in this regard, offering only that the Fed would ease further to halt deflation and that it “will do all that it can to ensure continuation of the economic recovery.”
There is equal uncertainty about future Fed policy once the economy recovers. A paper prepared for the conference, titledMonetary Policy and Stock Market Booms, by economists from the U.S. and Europe said central banks should lean against the disinflation and credit growth that accompany sharp rises in the stock market.
In general, the consensus had held that a central bank should lower rates amid the lower inflation that comes, for example, with a positive technology shock to the economy. In contract, the paper concluded, “A sharp rise in the interest rate is the efficient way to resist the desire for households” to increase spending during a boom and to control credit growth.
Compare that with what Charles Bean, deputy governor of the Bank of England, describes as one of the seven tenets of the Jackson Hole Consensus: “While asset prices might be subject to bouts of ‘exuberance’ on the part of investors, there was little that monetary policy could do about them. The best monetary policy could do was limit the fallout when sentiment turned.”
Now, he says, “In the absence of other instruments, the case of ‘leaning against the wind’ by setting policy rates higher during the boom phase seems stronger than before.”
One reason for this case, argued some in the coffee klatches of the conference, is that the very idea of only limiting the fallout of the boom can make the bubble worse, increasing moral hazard. Why shouldn’t investors play fast and loose if the Fed is saying it has an express policy to limit the effects of the crash? Would we all drink more if there was a proven cure for hangover?
Another of Bean’s ingredients of the Jackson Hole Consensus is under fire: is the central bank the best institution to manage the macroeconomy? Fiscal policy, left for dead by the Jackson Hole Consensus, has returned in force to help combat the financial crisis. Bernanke in his speech acknowledged, “Central bankers alone cannot solve the worlds’ economic problems.” In addition to efforts by central bankers, he said, “Fiscal policy… also helped to arrest the global decline.”
But one of Bean’s tenets of the Jackson Hole Consensus was that “fiscal policy was unsuitable” to manage the economy.
Time again, economists and central brought up the work of David Ricardo, the noted 19th-century economist who argued that government spending now doesn’t cause any additional household spending because people know they will have to pay taxes later.
Jean-Claude Trichet, president of the European Central Bank, tried to reclaim the Ricardian high ground in a luncheon speech on Friday, where he argued that cutting deficits now would actually help economies improve now. He said it would bring forward future spending because people would no longer expect future tax increases to pay for the government deficits. But Bean had to acknowledge the other side of the debate: When the central bank has lowered its rate to zero, there is precious little left but fiscal policy.
If there was any consolation, it was the paper by Eric Leeper, professor of economics at Indiana University, who wrote that it was time for fiscal policy to make the leap from pure politics to science. In other words, however unclear monetary policy might be, the current state of thinking around fiscal policy was far worse.