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Issues under discussion at Jackson Hole

I will not be attending Jackson Hole this year but I will be thinking about some of the issues under discussion. As I have written recently, I think coming times will be more challenging for central banks than the preceding few years. I will sleep best at night if Janet Yellen is reappointed as chair of the Federal Reserve.

Even though the Fed has raised rates more than I would have preferred and done far more signalling of future rate hikes than has seemed reasonable to me, or for that matter to the markets, it could have been much worse. I do not see a case for a further rate increase on current facts and remain very concerned that macroeconomic policy has inadequately internalised all the aspects of large declines in the neutral real rate and secular stagnation risks.

I have recently rehashed the issues bearing on inflation and monetary policy. The salient points are (1) inflation is below target and expected to remain well sub-target for the next five, 10, 20 and 30 years; (2) it has been well below target and Fed forecasts for a decade suggest great scepticism about models that predict acceleration; (3) the 2 per cent target is supposed to be an average so inflation should sometimes exceed it especially after a long shortfall; (4) if the ninth year of expansion with unemployment approaching 4 per cent is not the time for above target inflation when will that moment ever come? (5) it is better to make correctable errors and, as we have learnt painfully over the last decad,e inflation is more easily addressed than deflation.

Against this are posed two main lines of argument. The “sudden stop” theory holds that if inflation accelerates too much, the Fed will have to raise rates fast to stop it and send the economy into recession. The evidence cited by Boston Fed president Eric Rosengren is that whenever unemployment rises by more than a few tenths of a per cent it rises a lot as the economy goes into recession. What does this prove? When the Fed has raised rates to stop inflation, as in 1982, it has wanted to slow the economy way down. The failure to achieve a gentle slowdown when it was not the objective proves little.

These arguments are unsettled but pretty well discussed. Progress is likely to require a greater understanding of the breakdown in the Phillips curve than we now have. I suspect, especially given the press previews of Ms Yellen’s speech, that issues around monetary policy and asset prices will loom large in Jackson Hole.

The “financial conditions” argument regarding monetary policy has been made most strongly by NY Fed President Bill Dudley. It holds that recent monetary policy tightening has not tightened overall financial conditions as reflected in credit and term premiums, stock prices and foreign exchange values. The implication is that further tightening is necessary to regulate demand and also to avoid bubbles.

The fatal flaw here is failure to recognise the importance of fluctuations in the neutral rate and market perceptions of its future level. Suppose, as has been true in recent years, the neutral rate falls. That reflects a decrease in investment demand relative to saving supply and so is a reason, other things being equal, for easier money. What will happen to some financial conditions index? Stock prices will rise because of a lower discount factor. The dollar will fall because of lower rates. Long rates will fall because of reduced real rate expectations. Financial conditions indices will show great ease even when developments call for more easing.

Similarly, judgments about bubbles need to be reached in the context of the level of neutral rates. Levels of price-earning ratios that would have looked bubbly with a 2 per cent neutral real rate are much less so with a zero neutral real rate. Moreover, judgments about bubbles need to be made in context of fundamentals.

The Fed seems more alarmed this year than last about valuations but the reality is that the ratio on the S&P 500 relative to either trailing or forward earnings has remained stable. Surely the weakness of the dollar is a reflection in significant part of strengthening fundamentals in Europe, which if it signifies greater competitiveness is a reason to ease not tighten.

There is a further point. Monetary policy works with long lags. If policy makers were confident that asset markets were at bubble level, what is the right response? Should they prick the bubble? Or suspecting that it is about to burst should they, in Tim Geithner’s famous phrase, “lay foam on the runway” by keeping policy easy? The case for financial stability tightening rests on an ability to see bubbles well in advance. That is asking a lot.