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.

Jackson Hole Wyoming
James Randklev | Photographer's Choice RF | Getty Images
Jackson Hole Wyoming

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.

"After saying that the Fed was ready to “strongly resist” deflation by purchasing more Treasurys, Bernanke acknowledged that the Fed “has not agreed on specific criteria” for further action."

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.

Read about the "Minsky moment" and more

Another of the building blocks of the consensus—and here, central bankers were shamefully wrong—is that if you took care of price stability, the economy and the markets would take care of themselves. In other words, central banks needed only to be headed by macroeconomists.

If they got it right, regulation could be minimized and regulators pushed to the background. As Bean put it, the consensus held that, “asset markets were thought to be efficient at distributing and pricing risk and financial innovations were normally welfare enhancing.”

Now, all we hear about is how essential bank regulation is and how vital it is to the conduct of monetary policy.

Many more elements of the Jackson Hole Consensus are crumbling, including the idea that stability begets stability. The late economist Hyman Minsky came more and more into the discussions for his theories that every boom period has within it the seeds of its own destruction because it breeds complacency and excess. This leads to the fabled Minsky moment, when investors are forced to sell even good assets during a crash.

Former Fed Vice Chairman Alan Blinder suggested that the current trendy economic models should begin trying to capture the effects described by Minsky to better guide central bank policy. That is, central banks need to be mindful of the effects on investors and on the economy of being successful.

It would be wrong to leave the summation of the proceeding at Jackson Hole without mentioning the ever-present insistence by StanfordUniversityeconomist John Taylor that there is no reason to change policies. Taylor, author of the famous Taylor rule for guiding central bankers to the right interest rate policy, has maintained since the crisis began that the key to the errors in policy were the deviations from his rule. That is, interest rates were too low for too long and caused the bubble. Bean argued that low-interest-rate policies were only a small reason for the overleverage.

From debate over the economic models to questions over the right policies in good times and in crises, it is hard to remember a time when central bankers were both so divided and so uncertain. For monetary policy, the financial crisis has been the geologic equivalent of the faults that uplifted the Grand Tetons.

Perhaps from these fissures in policy will come a new consensus that can guide central bankers toward better outcomes when they meet in the next decade beneath the towering Tetons.