While historically the Kansas Fed’s Jackson Hole symposium has not lead to dramatic market moves (with the exception of 2010 when Ben Bernanke unveiled QE2), it has traditionally served as a springboard for the Fed to prepare the market for any major shifts in policy, such as the 2013 tapering of QE. So having skipped the 2015 central banker conclave, all eyes will be on Janet Yellen this Friday, where as Bloomberg’s Daniel Kruger predicts it will be all about “coming to grips with the idea that our economic future is currently staring back at us in the mirror” as a result of numerous recent admissions by current and former (most notably Ben Bernanke) central banks, who have been increasingly focused on r*star (or the natural interest rate) as an indication that the US economy can no longer grow at its historical pace absent a major fiscal stimulus.
The topic of the meeting (“Designing Resilient Monetary Policy Frameworks for the Future“) belies the notion that some hard truths are going to be served up. Among them should be acknowledgments that the Fed’s terminal rate is lower than officials have forecast and that central banks, once seen as omnipotent, have thrown their best punches and will be operating from positions of weakness for the foreseeable future. In other words, as Kruger puts it, this is the new normal, and it could get worse.
The WSJ’s Jon Hilsenrath confirms as much, saying that “for much of the post-financial-crisis era, U.S. Federal Reserve officials have held to a belief that they could get back to their old way of doing things. Growth would resume at a modest pace, annual inflation would climb to 2% and interest rates would gradually rise from near zero to a normal level near 4% or higher.” However “as they prepare to gather at their annual retreat in Jackson Hole, Wyo., officials are grimly coming to a view that it isn’t going to happen that way.”
Hilsenrath admits that the Fed, in turn, “is starting to see that rates aren’t going to return to normal and the way it conducts monetary policy and deals with recessions is going to have to change.”
“New realities pose significant challenges for the conduct of monetary policy,” San Francisco Fed President John Williams said in a research note released last week on the shifting monetary policy landscape.
In this world, unconventional tools used after the financial crisis – including purchases of long-term Treasurys to push down long-term interest rates and assurances of low short-term rates into the future – could be rolled out when another downturn hits. A portfolio of securities, now $4.2 trillion, could grow. Unpopular interest payments to banks for their deposits at the central bank could persist.
In other words, all Yellen will admit is that having thrown everything at the problem, the Fed will likely end up having to throw even more at it: “The new normal, in short, could look a lot like what the Fed has been doing for the past several years.“
However, there is a problem: for QE to work, there has to be a substantial source of debt issuance; and since both the US and other nations are finding themselves with rapidly shrinking deficits as a result of collapsing global trade, and thus lower debt issuance, the Fed and other central banks have come up with just the solution: “fiscal stimulus”, which is simply a code word for more debt issuance, which in turn would permit both the Fed, and its peers, to monetize even more debt during the next economic downcycle.
AS for hiking rates, that ship has now mostly sailed, as Hilsenrath explains:
This isn’t to say the Fed won’t raise short-term rates again sometime this year. Many officials expect it will. The Fed boosted its benchmark federal-funds rate—a rate on overnight loans between banks—by a quarter percentage point from near zero in December. But it does mean it isn’t likely to raise them much beyond its next few moves in the months and years ahead.
“We probably don’t have a lot of monetary policy tightenings to actually do over time,” William Dudley, president of the Federal Reserve Bank of New York, told Fox Business Network.
Not surprisingly, Dudley is one of the biggest Fed doves.
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And yet, one bank refuses to accept that the Fed’s hiking cycle is largely over. That would be Goldman Sachs, and specifically its chief economist Jan Hatzius, who as recently as two years ago was predicting above-trend growth for the US economy (so much for that), and now sees “a subjective 30% probability that the next move is a hike at the September meeting and a 45% probability that it is a hike in December, for a 75% cumulative probability of at least one rate increase this year. So our baseline expectation is that the committee will stand pat in September and wait until December before moving, but encouraging news between now and September 21—in particular another very strong employment report for August published on September 2—could lead us to change our modal call.”
Ironically, in a rhetorical Q&A, he admits that he is putting a lot of weight on the Fed’s guidance, despite acknowledging that “the central lesson of 2016 is that they will always find an excuse to be dovish, no matter what they say?”
And here is how Hatzius “explains” why both the Fed’s inability to hike, and his own flawed forecasts, have become the laughing stock of Wall Street where everyone now admits the Fed has a credibility problem:
There is no doubt that the committee’s communication has been rocky this year, especially in the spring and early summer.
Following a distinctly dovish speech by Chair Yellen on March 29 and a relatively neutral statement after the April 26-27 FOMC meeting, the minutes of that meeting released on May 18 surprised virtually everyone by guiding strongly toward a rate hike in June or July, and Chair Yellen reinforced this message in her remarks at Harvard University on May 27. But the weak May employment report released on June 3 and increased concern about the UK referendum again triggered a sharp pivot, putting on hold the notion of further hikes. These dramatic shifts have frustrated many market participants.
And the punchline:
In our view, the Fed has been unlucky. We think they really did intend to hike in June or July but were thrown off course by the weak employment report and the darkening shadow over the global economy from the approaching UK referendum. With both of these issues now largely resolved, we feel quite confident that the committee is planning to hike again, provided the economic data and financial conditions are sufficiently supportive.
So what is that in S&P500 terms: 2,300? 2,500? And if that is the case, when will Goldman finally change its year end S&P target of 2,100 especially since the market closed on Friday less than 120 points away from Goldman’ 2018 year end forecast.
Ah, the new normal, where hope is a strategy, and where it’s not the arrogant cluelessness of a few Fed economists, but the lack of luck the explains the failure of monetary policy.
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Finally, for those curious, what Goldman thinks on the topic du jour, namely r*, here is the relevant section.
Q: Is the committee’s increased pessimism about r* likely to trigger fundamental changes in its monetary policy framework, e.g., a higher inflation target or a move to a price level or nominal GDP level target as discussed by San Francisco Fed President Williams this week?
A: This discussion is likely to feature prominently in the upcoming Jackson Hole symposium on Designing Resilient Monetary Policy Frameworks for the Future, and it may well come up in Chair Yellen’s opening remarks on Friday. The basic idea is that a lower r* requires a higher average inflation rate to keep the average nominal funds rate sufficiently high to limit the risk that adverse shocks push monetary policy to the zero bound on a frequent basis.
But we do not expect a significant change in the framework anytime soon. First, Fed officials themselves don’t seem to be in a hurry. President Dudley said in his Fox Business News interview this week that it was “premature” to talk about a higher inflation target at this point. Moreover, President Williams himself does not want to change horses in midstream; indeed, he has been pushing for rate hikes for some time, including again this week, and thus shows no sign of tacitly targeting a higher inflation rate at this point.
Second, even assuming a sufficient consensus developed within the Fed in favor of a different framework, such a change would be difficult to implement. The notion of higher inflation is not popular, and we would expect pushback against a redefinition of the “stable prices” mandate from the current 2% inflation target to something higher.
Third, the behavior of the economy itself will shape the debate. Under our forecast of decent growth and gradual increases in core inflation and short-term interest rates, the perceived level of r* is unlikely to come down much further and may well rebound eventually; in fact, our own (admittedly highly uncertain) estimate of the longer-term equilibrium funds rate is 1¼%-1½% in real terms and 3¼%-3½% in nominal terms. Stabilization in the perceptions around r* reduce the urgency of any changes to the policy framework.
To summarize using Hilsenrath’s own words, what Yellen is about to reveal on Friday, “will look a lot like what the Fed has been doing for the past several years.” But expect a lot of drama and financial media spin to explain how the Fed doubling down on even more failed policies (hopefully this time with Congress issuing even more debt) is a “bold and new” monetary policy.
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