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.