2024-08-27 11:30:34
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With the much-anticipated Federal Reserve policy adjustment approaching, much of the coverage of this year’s Jackson Hole conference has focused on signs of where interest rates are headed in the coming months.
Although central bank governors generally agreed that loose policies may be adopted in the short term, there was less consensus on the theme of this meeting: “monetary transmission and its effectiveness.”
Policymakers appear to have reached different conclusions about whether the monetary policy tools at their disposal over the past few years have worked as intended. They also appear to have different views on whether the monetary transmission mechanism will work in a predictable way when the next crisis comes.
Let’s look at what the central bankers concluded — and what they can learn from each other:
Powell: Business as usual
Although it is very cautious, Keynote speech by Federal Reserve Chairman Jay Powell Demonstrates overall confidence in a job well done.
His diagnosis of the U.S. economic problems of the past few years was clear and confident. In his view, those challenges are now “fading.”
“Much of the increase in inflation [was due to] “You have a very unusual conflict of overheated and temporarily distorted demand and constrained supply,” he said. In this situation, the Fed’s job is to “regulate aggregate demand, [to anchor inflation] expectations”. He believes it has succeeded on both counts.
His speech conveyed two messages.
First, the monetary transmission mechanism played its due role through financial conditions and expectations. As Powell said, “our tight monetary policy has helped restore the balance between aggregate supply and aggregate demand, eased inflationary pressures, and ensured that inflation expectations are well contained.”
Second, the supply and demand shocks that caused inflation to exceed target did not introduce structural changes to the U.S. economy. This means that it is reasonable to expect that the monetary tools that worked this time will work in much the same way the next time a crisis hits.
What Powell did not mention is that the Fed upgraded its policy framework in 2020 to a new approach — flexible average inflation targeting — that aims to “offset the downward bias in inflation expectations caused by the lower bound of inflation targeting,” as New York Fed President John Williams put it. Under FAIT, when current inflation is below the 2% target, future inflation can exceed the 2% target.
Powell pointed out that since then, U.S. inflation expectations have been doing well, falling sharply from the highs in 2022. But if the Fed’s interest rate does not return to the lower limit, it may mean that this time, the Fed has more room than in the future to allow expectations to move up.
Bailey: In the dark
Bank of England Governor Andrew Bailey The tone is far less confident.
First, he noted that the Bank of England has not been entirely successful in managing inflation expectations. “Internal inflation persistence means that price and wage setting behavior does change. [ . . . ] “It’s still with us,” he said, though he added that the numbers have dropped slightly over the past year.
Second, Bailey does not seem to have a clear idea of just how much policy restraint is needed to squeeze out any remaining staying power, or indeed, which monetary transmission channel would best achieve that goal.
“Is the recession that is now persisting almost inevitable? [ . . . ] Or does a negative output gap also need to emerge, or are we experiencing more permanent changes in the setting of prices, wages and profit rates that require monetary policy to remain tight for longer?” he asked the audience.
Bailey’s uncertainty didn’t end there. Elsewhere in his speech, he noted that the monetary transmission mechanism may not be working as policymakers expected this time around — both because of major structural changes in the economy since the last tightening cycle and because of the idiosyncrasies of moving up from near-zero interest rates.
If the shift from ultra-loose to tight policy changes the transmission mechanism, then this is of interest not only to the Bank of England. In any case, he correctly points out that a lot has changed in the global economy since the last global tightening cycle.
Ryan: Environmental help
Like Powell, ECB Chief Economist Philip Lane is confident about the ECB’s policy stance Transferred as expectedBut he noted that, as with the UK, “the return target is not yet certain”.
But his description of the various monetary transmission channels suggests that their formation is driven by a number of external factors. At least some of these factors should not reappear the next time the ECB needs to raise interest rates, which means that in future crises, the ECB’s strategy may also have to change.
Turning to the impact of tightening on aggregate demand, Ryan said weakened consumer confidence and soaring energy prices after Russia’s invasion of Ukraine “reduce the degree of demand suppression that monetary tightening needs to produce.” This means that if the next round of high inflation is caused by a shock that is the opposite of tightening (such as a positive demand shock), monetary transmission will be less powerful. The lessons of past tightening cycles may not necessarily apply.
Ryan said the ECB’s tight policy had also prevented inflation expectations from destabilising, but he also noted that “inflation expectations had already destabilised to a downward trend in the post-crisis years before the pandemic”.
In other words, Ryan made clear what Powell did not: the ECB had extra room this time to let medium-term inflation expectations rise, allowing for a softer, more gradual tightening. With expectations now higher than before the pandemic, there may not be such room next time.
It is also interesting to compare Lane and Bailey’s conclusions on the impact of negative demand and supply shocks, as they are similar for the euro area and the UK. Lane seems to argue that slowing real activity drags down inflation, while Bailey argues that rising inflation fuels expectations, which even very tight policies cannot fully offset.
Data showed underlying inflation measures, including core and services, peaked in the U.K. Does the British economy face its own unique problems, such as low labor force participation, which makes it harder for high interest rates to control inflation? Or is Ryan at risk of a surprise?
Understanding the monetary transmission mechanism is important for central bankers. Knowing exactly how trading instruments work can reduce the risk of costly policy mistakes. We don’t know how Powell, Bailey, and Ryan’s views on this topic evolved after their weekend discussion at Jackson Lake Lodge—but we have reason to believe what questions they raised.
Things I’ve read and watched
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With deflation spreading and economic activity clearly weakening, it is time for central banks to throw caution to the wind – or risk falling behind, argues Andy Haldane, former chief economist at the Bank of England.
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Mohamed Elian also believes that Powell has failed to fully clarify the Fed’s interest rate path after September, but his main concern is that the lack of transparency has led the market into a quagmire of unconstrained easing. Only a few weeks after the shock in early August, the risk of another relapse in the market is increasing.
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Before Powell’s speech, Adam Posen wrote that the Fed chairman should use his platform to highlight the economic damage that some of Trump’s campaign promises will cause to the United States. He also said that given the uncertain fiscal outlook, Powell should not rule out the possibility of raising interest rates again next year.
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Kamala Harris’ ideas on housing have not been well received, but blogger Noah Smith (Noahpinion) makes a counter-argument (which I think is pretty convincing). piece Why they do work.
Important charts
In 2022, Western central banks began to implement quantitative tightening policies in order to give themselves maximum firepower to deal with the next crisis.
But policymakers have different views on the ultimate outcome. The Fed wants to continue to provide all the liquidity the financial system needs, while the Bank of England wants to at least partially restore on-demand liquidity. The ECB is somewhere in between.
After 2008, central banks around the world shifted almost synchronously from scarce reserves to abundant reserves. In the post-epidemic era, there may be divergences in the balance sheet management policies of central banks around the world.
Whatever the outcome of this complex and slow-moving debate, the BIS’s new database will be an invaluable tool for those who pay attention.
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