This month’s Jackson Hole symposium is intended to address the ‘challenges for monetary policy’. In reality, the debate will probably be around the merits or otherwise of the US Federal Reserve (Fed) continuing to cut interest rates or not.
The Fed finds itself at a taxing junction. It needs to reassure investors that it has the measure of the economy and can deliver a consistent message after some fairly major communication missteps in recent months.
That said, there is a much bigger challenge that should be on the agenda at Jackson Hole. The Fed launched a review last year into its methods and goals – and there is a real risk that it is prejudging the conclusion.
A golden opportunity
The review is a golden opportunity for the Fed to look at what it does and how it does it. This is important, because the Fed has undershot its 2 per cent inflation target for all but five months since 2012.
Investors have little faith that the central bank will hit its target. This means the target itself has become a less powerful reference point for the economy.
But the way that the review has been framed seems to imply that the solution to the Fed’s quandary is to change the framework it uses.
The Fed is proposing to switch to a framework that will mean it has to make up for times when inflation has missed its goal. It sees this as a way of improving its inflation targeting credentials. But the problem is that the Fed cannot put all the blame for its inability to hit its inflation target on the framework or tools that it has at its disposal.
The Fed has consistently:
- underestimated the degree of spare capacity in the economy;
- overestimated the level of the equilibrium interest rate, and (partly as a result of both of these)
- delivered inflation forecasts that were too high.
As a result it provided insufficient policy support after the financial crisis and sought to prematurely withdraw this accommodation on several occasions. The Fed delivered intermittent blasts of quantitative easing, committed a policy error during the taper tantrum, and arguably tightened policy too readily over the past 18 months.
In other words, the Fed made mistakes and did not even use all of the tools that it had at its disposal. So it is not obvious that a new framework will solve these errors.
Even if the framework was the problem, simply switching to a different one would not provide a panacea. All that would do is shift the Fed’s aim from one target to another. If an archer were consistently missing the bullseye no one would suggest that the solution was to keep doing exactly the same but to aim at a different target.
To restore investor confidence in its inflation targeting credentials, the Fed needs to go much further than just looking at their framework. It needs to engage in a far more fundamental debate about its policy mistakes – and how to avoid them in future. At a basic level, any review of its current framework should probe why the Fed is so bad at forecasting inflation.
More broadly, it should look at the inflation process, and some of the reasons that have held price growth back in recent years. A review of its tools for understanding the supply side more generally would be a good start.
Time for reflection
But there is nothing about the current mood music to suggest that the Fed is feeling reflective about its own shortcomings. That is worrying. If the Fed carries on down this path, investors will establish that it is prescribing a solution without understanding the problem.
An exercise intended to improve credibility may well end up damaging it further, entrenching low inflation expectations further and making any future attempt to restore faith much more difficult.
The precedent of the Bank of Japan should be ringing in the Fed’s ears. It tinkered with its framework in a bid to regain the confidence of investors, but then failed to get anywhere near its inflation target and lost even more credibility in the process.
Jackson Hole would have been the ideal forum to starting addressing the problems at the root of the Fed’s policy making process. By talking about all the wrong things it risks demonstrating that it does not understand the problem. It may still have time to spot the error of its ways. But the clock is ticking.
The above article was previously published by Aberdeen Standard Investments on 22nd August 2019