There have been two conversations going on at the Federal Reserve this summer.
The first, not surprisingly, has been the timing of the next rate hike. As job growth has rebounded and Brexit risks have subsided, some participants within the FOMC have begun to signal a rate hike as appropriate by year-end. At the same time, another discussion is taking place that is gathering a lot of attention. Specifically, is the Fed prepared for the next recession and how should monetary policy operate efficiently in the longer run?
With growing acceptance amongst academics and investors that interest rates and growth will remain lower for longer, the question has become what policy makers will do to stimulate growth next time around when interest rates are already very low. The Fed appears to be at an inflection point in its policy regime as it is being forced to contend with cyclical (less responsiveness of wages & inflation to diminishing slack) and structural issues (think demographics, productivity, regulations, etc.).
The market is now waiting for clarification on these two conversations. This clarity could come from Chair Yellen on Friday at the Jackson Hole conference. The theme of the conference this year is “Designing Resilient Monetary Policy Frameworks for the Future” and the title of Yellen’s speech is “The Federal Reserve’s Monetary Policy Toolkit”. What Yellen will address may or may not satisfy the market’s curiosity. Our view is that investors are more likely to get a detailed discussion on the latter (long-run policy discussion), rather than the former (current policy expectations).
Investors will likely be dismissive of Yellen’s cheerleading of the US economy’s resilience and the economic progress made since the Fed first raised rates in December 2015. Markets will also likely gloss over any discussion of the existing monetary policy tool kit: interest rate policy, quantitative easing/large scale asset purchases, and forward guidance/communication. Yellen will likely communicate confidence that these existing tools will be sufficient in most cases to stimulate the economy.
A large emphasis on the need for complementary fiscal policy will also likely be incorporated into her message. Since monetary policy can only act within the confines of the long run neutral interest rate (R*) which is set exogenously, a discussion of structural reforms that can be done to raise R* and reduce this constraint on the central bank will likely be considered. We’ve already received glimpses from Williams, Dudley and former policy makers on this topic.
Next will come a discussion of what the Fed can do beyond these existing tools. To minimize the constraint of the zero-lower bound and lower real rates further, the Fed could consider raising the inflation target, price-level targeting, or nominal GDP targeting. If price-level or nominal GDP targeting is introduced, it will likely be in a theoretical rather than a practical way. Since these policies have never been implemented before at any central bank (with the exception of the Riksbank’s brief implementation of price level targeting in the 1930s) and the Federal Reserve operates on a slow moving consensus, Yellen’s speech is unlikely to include any official announcement or endorsement of an imminent change to the Fed’s current framework and 2% inflation target.
What would really pique investors’ interest would be a discussion of the impact of her analysis on current monetary policy. This discussion may or not may not occur at this engagement. If the conversation does not happen, we would view this as a missed opportunity by the Chair. Investors are expecting a clear roadmap as the Fed transitions to a new policy framework.
Near term policy action and the longer-run framework at the Fed are currently separate issues for the FOMC. However, at some point these views between what is appropriate by year-end and the “longer-term” will need to converge. This convergence will define the path of policy for the remainder of the current cycle, shaping how yields and the curve behave over the medium-term. The Chair has an opportunity to reconcile the current time-varying policy objectives being considered by the FOMC and provide the market with some much needed clarity.