The annual Jackson Hole symposium on monetary policy starts this week. It will be about “Fostering a Dynamic Global Economy”: In other words, central bankers will sit down to discuss long-term goals and avoid publicly communicating policy decisions, if recent news reports about the Federal Reserve and the European Central Bank prove accurate.
But make no mistake, this year’s meeting is critically important. Two topics should dominate the conversation. The first is why despite falling unemployment, inflation remains elusive. The second is how to coordinate an exit from quantitative easing measures. Those two topics are not at odds. There are good reasons why central bankers should want to exit QE even though inflation remains far below their targets.
Economists are split on why inflation has lagged gains on growth and unemployment. The Fed has reassured low inflation is temporary, but many believe structural factors will keep inflation lower for longer than traditional models suggest. We are in that camp. The scars left on the economy by the prolonged recession – such as workers permanently dropping out of the workforce, new technologies that maximize sharing of existing resources, falling demographics, and a general weakening of labor bargaining – are all responsible for keeping inflation subdued.
If inflation is likely to remain low due to structural factors, then QE may be less useful than previously thought. In fact, continuing QE can expose markets and the economy to two risks. The first is that over time, persistent low interest rates may become self-defeating. Absent a fiscal policy stimulus, low interest rates may lose their impact or even become deflationary: aging populations save more to make up for lower returns, firms invest in new technologies employing fewer workers, and workers who were trained in sectors that were booming during the crisis remain permanently out of the workforce.
The second risk is that QE will generate dangerous side effects, including asset bubbles, rising wealth inequality, and a misallocation of resources in the economy. Negative or zero rate polices have pushed investors into search-for-yield strategies, distorting the risk premium in credit and volatility. QE has favored the haves over the have-nots, contributing to wealth inequality and to an asset-rich, wage-poor recovery. Finally, NIRP/ZIRP can encourage resource misallocation by keeping alive zombie companies.
An exit from QE is therefore overdue, both to prevent formation of bubbles in asset markets as well as to build a policy buffer before the next slowdown.
Although central bank chiefs agreed on a hawkish path for monetary policy at their June meetings in Sintra, Portugal, what followed shows why exiting QE will be difficult. Long-term interest rates initially rose, led by German bunds on ECB President Mario Draghis reflation rhetoric. That move faded, however, as the euro strengthened and economic data in the euro zone undershot expectations, while U.S. data surprised on the upside.
To successfully exit QE requires the coordination of multiple central banks as well as governments, if we consider the impact of fiscal policy. The lack of coordination created currency wars across central banks at the launch of QE, and the same can happen at the exit. But coordination is hard in a world with several central banks dealing with asynchronous economic cycles. The reality is that some central banks are in a better position to remove stimulus than others.
The Fed is ahead of the pack, though its dots path is at risk as the turmoil in Washington diminishes the chances for tax reform and infrastructure spending. This suggests a more dovish narrative, which bond markets are already pricing in.
The ECB is preparing to announce tapering before year-end, but the euros rapid appreciation may cause some delays. Even so, the euro zone economy is likely to continue surprising on the upside, thanks to a stronger political framework with Frances Emmanuel Macron and Germanys Angela Merkel pushing for greater integration.
There are also central banks that have talked or acted more hawkish than they can afford. The Bank of England faces a weakening economy, while the Bank of Canadas rate hikes have taken place on the back of a housing bubble and poor oil outlook. The U.K., in particular, is likely to face severe headwinds as Brexit uncertainty continues to hurt sterling, weighing on consumption and investment. This means that despite hawkish talk by Mark Carney, a rate hike remains unlikely in the coming quarters.
Will central bankers agree on a coordinated exit at Jackson Hole, or will currency wars start again? Both a coordinated tightening and a disorderly exit are likely to generate substantial volatility, as we have seen over the past few weeks.
Yet markets seem to ignore these risks. At a time when central bank ammunition is as scarce as its ever been, investors are increasingly reliant on it. The assumption that you should buy the dip and never fight the Fed developed during the Alan Greenspan era is still in vogue. Many investors still believe central bankers are in control of markets and of the future, but with much less room to cut rates and expand their balance sheets compared with 10 years ago, this may no longer be true. We may be about to learn whether central banks are still masters of the universe or emperors with no clothes.
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