The Jackson Hole Spaghetti Toss
By Rob Parenteau
The Jackson Hole gathering of central bankers convenes on Friday, and the timing could not be better: Christmas in August, anyone? Last year’s mere mention of a possible second round of quantitative easing by Chairman Bernanke was enough to carry equity indexes into the spring. After enduring cascading equity prices for the past month, investors are figuratively on their knees, praying for a repeat performance. But since QE2 obviously failed to secure ever rising equity prices and a return to trend real GDP growth, there is a dangerous question looming: what can the Fed really do?
Obviously, Chairman Bernanke has to throw more spaghetti at the proverbial wall, regardless of the internal discord apparent at the Fed (evident in the speeches of Governors Fisher and Plosser last week) or the external political heat they are facing as they have waded deeper into the bog of unconventional monetary policy. But frankly, I am at a loss as to which strand of spaghetti will actually stick in terms of a) capturing the imagination and confidence of investors enough to embrace the “risk on” trade again for more than a few weeks, and b) driving US real GDP growth above trend for 2-3 years. Which makes me think unless there is some nuclear option he is prepared to launch – something virtually unthinkable like getting his legal staff to approve pegging S&P futures for 10%+ annual appreciation until trend real GDP growth settles in – there is not much to be gained by trying to anticipate the size or shape of his next policy flinch.
Rather, it feels like we are at the point of watching the trout thrash around at the bottom of the boat. Arguably, some part of the higher required risk premium we are in seeing in asset markets today may be a reflection of a new understanding that the Fed Chairman is no more powerful than the Wizard of Oz. If so, this is a very, very big safety blanket that is being ripped out of the hands of a whole generation of institutional investors (especially the long only pension fund managers who are paid to play). Perhaps that is the new investable theme. The severity of the recent cascade in asset prices may have more than a little to do with the growing recognition that the prior fiscal and monetary policy approaches have either been exhausted or politically blocked, and that leaves it all up to the invisible hand to do its magic.
Maybe an announcement of pegging the 10 year U.S. Treasury yield at 1% until real GDP has grown for above 3% for 1-2 years would do it – but we are already near 2%, and people seem to realize the interest rate sensitivity of economies can be remarkably lower than usual after balance sheet recessions. In the vernacular of old school macroeconomists, it is not a nearly flat LM curve (a la Paul Krugman’s relentless concern with a liquidity trap) that needs to be addressed, but rather, a near vertical IS curve – with the personal gross saving rate still elevated despite negative real bank deposit rate, and business reinvestment rates still too low despite 100% depreciation of equipment spending this year.
Maybe an open ended QE with a similar real GDP requirement would do it, but surely investors must be wondering why QE2 failed to keep equity prices on a permanently higher trajectory. More importantly, investors may have noticed that the commodity price inflation that appears to accompany QE moves tends to trip up consumer spending when slow job growth, low wage growth, and a household credit contraction are all in play.
Maybe the Chairman could boldly announce the Fed disagrees with the Treasury about the wisdom of a “strong dollar” policy under current conditions, and will henceforth unilaterally intervene to produce a steady 10-20% depreciation per year until trend real GDP is accomplished. If higher import prices are what the good doctor intends to order, why will those have any more favorable effects than higher commodity prices did, and are we just off to the beggar thy neighbor races with the Bank of Japan, and later the Bank of England?
Merely listing these possible “better than expected” policy moves that could be hinted at (or even trumpeted) in the Chairman’s speech on Friday reveals the absurdity of the situation we have arrived at. A policy move dramatic enough to capture investor imaginations is required. Incremental moves, like dialing the interest rate on bank reserves down to zero, or reinvesting proceeds of existing Fed holdings in longer maturity debt, are unlikely to cut it after the harsh cascade of equity prices in August.
If the Chairman has to do something, then the real question is what policy response is adequate to a) reviving asset prices and b) returning the US to trend real GDP growth (since the portfolio balance channel appears to be the only one left for monetary policy transmission to work). Many institutional investors may be realizing that is a null set given current political configurations, and so whatever the Chairman delivers – even if he goes boldly where no Fed governor has ever gone before – may have a very short half life, as we saw with the last move of pegging the 2 year US Treasury yield at the fed funds rate. Perhaps the moment has arrived when we collectively realize central bankers are not the omnipotent demigods that a generation of investors has expected them to be – and maybe that is a big step forward for us all. After all, a lifetime ago, even J.M. Keynes had to admit monetary policy could fall short.
Rob is the sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute.
First off you said “after a balance sheet recession.” That’s funny!
Second, if the Fed were to announce that it would pay $1 to anyone presenting it with 3 RMB, the economy would be out of recession within four quarters. Not that anyone will actually propose doing that.
Balance sheet recession refers to Richard Koo’s work, which in some respects is a very diluted version of Hy Minsky’s work on financial fragility.China’s policy makers would face a revolt by China based exporters if you could get that exchange rate.
Well I can’t get that exchange rate, but the Fed could. All they have to do is print dollars and buy RMB with them. Who can stop them?
“after a balance sheet recession.”? We are still in it. We have been for four years.
Krugman is right that there is a liquidity trap. All the additional funds from QE are flowing into speculation on currencies and commodities. Money is not flowing into credit because banks are stricter with credit now, which is what they should have been doing for years. As for the savings rate being higher it was artificially lower for the last decade or longer, and should be considered as returning to a more normal level rather than being elevated now.
Generally central bankers are in a hole and they are not doing much to dig themselves out. Though the problems with excessive credit are not solved by easier credit or lower rates. Until debts are down to manageable levels growth will be constrained.
Am going by conventional NBER business cycle dates.
Liquidity traps usually refer to inability of monetary policy authorities to reduce longer term interest rates. The conditional promise to keep fed funds pegged low into the summer of 2013 at the last FOMC meeting did seem to be associated with lower long Treasury yields. So this is not a liquidity trap. The liquidity is trapped on bank balance sheets, where excess reserves are being held, as there remains a dearth of creditworthy borrowers, and a desire to deleverage by households. The Fed’s moves have encouraged (by design) portfolio preference shifts toward commodities and other risky asset classes, but the money the Fed has created is being hoarded by banks. Bank assets have barely grown – there is no bank lending boom to commodity speculators that I can identify. Problem is less with household saving rate than low rate of private investment, which in part reflects the hangover effects of the housing bubble, but also ultra myopic incentive structures for CEOs and institutional investors. Domestic private debt loads do need to
be reduced, but as the sector financial balance equation reveals, that requires improving trade balance or deeper fiscal deficits or some combination thereof. Neither option appears at hand, so household debt is shrinking mostly on defaults, while nonfinancial corporate sector is releveraging…to buy back shares and boost stock prices, not to put lower cost or more innovative capital equipment in place.
Firstly this is not a normal recession. We have a multigenerational asset bubble in the process of unwinding. My personal definition of a liquidity trap is if pools anywhere without flowing. Central banks can still influence long term rates for now. Banks are using the money themselves for commodity speculation. So much for firewalls between segments of the bank.
Investment will only take place if there is going to be a return on that investment. Also with growth prospects in the West being so poor why invest there. Hence, the flow of money to Asia.
I agree about the short-termism of managers and investors though the tax system actively encouraged it. WIth capital gains taxed at a lower rate than income it meant there were huge personal incentives to inflate property and investment assets to get capital gains rather than income.
Domestic savings rates were far too low in the US. If they had been maintained at a higher rate then the property bubble would have been smaller. Higher interest rates to maintain savings would have been a damper on property speculation. It would have also kept domestic spending lower and more manageable. They would have also been able to fund government deficits.
I do agree about the trade balance. The world needs to accept that the US needs to become an exporter for once or at least eliminate its trade deficit. Trade barriers would help that. Plus give companies a reason to invest in the US because finished goods will not be allowed in. Also it would reduce the need for there to be a large federal deficit.
Has the Fed any freedom to undertake any radical move such as interest freezing or monetary easing without taking into account the concerns of G-20, especially China? Gone are the days when Greenspan could work on the Fed as though the US was the center of the universe. No longer.
As long as Chinese producers demand US dollars as a means of settlement for US purchases of their exports, and as long as China runs a trade surplus with the US, China is stuck accumulating US dollars. They have zero veto authority over the central bank. They can choose to request payment in a different currency at any point in time, but they must be willing to accept the consequences of that decision. Please indicate evidence you find convincing of G20 considerations constraining Fed decisions. As far as I can see, the Fed has gone well beyond the conventional playbook, and is not asking anyone’s permission to do so, although maybe some highly placed Wall Streeters are used as a sounding board along the way.