This month central bankers from around the world will gather for their annual economic symposium at Jackson Hole, Wyoming. Hosted by the Kansas City Federal Reserve, it has established itself as the premier event to capture the mood of global monetary policy.
This year's theme is "macroeconomic policy in an uneven economy". As in most recent years, attention is on how to ensure that monetary policy is fit for purpose in a changing world economy.
For financial markets, the focus at Jackson Hole is almost always on what it means for the next move in American monetary policy. This year will be no different as the chairman of the Fed is, as usual, the headline speaker.
First, though, it is necessary to answer the question: where are we in the economic cycle? While each central bank will be driven by domestic factors, the global backdrop will help to determine where they and the markets see the balance of risks.
In the spring, markets were focusing on a strong rebound, particularly in the United States and Britain. This reflected vaccine rollouts unleashing pent-up demand, plus the scale of monetary and fiscal stimulus.
In turn, inflation fears leapt to the fore, as stronger demand, supply bottlenecks and higher commodity prices fed through. So far this year the annual rate of consumer prices inflation has risen from 1.4 per cent to 5.4 per cent in the US and from 0.7 per cent to 2.5 per cent in the UK.
Recently, though, inflation expectations in financial markets, while still elevated, are off their peak as attention has shifted to a likely deceleration in global growth next year, in turn raising fears that western economies will return to a pre-Covid trend of sluggish growth.
Against this backdrop, and with the additional uncertainty about the path of the pandemic, central banks have been reluctant to show signs of tightening soon. This creates a challenge for financial markets. While they benefit from continued accommodative monetary stances, there are risks about when and how central banks will exit their cheap money policies.
One consequence of policy rates being close to zero is that markets are not pricing properly for risk. This was also a problem ahead of the 2008 financial crisis. This has been compounded now by bond yields no longer reflecting true demand-and-supply dynamics. This is because of the actions of central banks that are non-commercial buyers. Central banks are doing their governments a massive favour by buying their debt and usually, because of their independence, they are not held to account sufficiently for this. Thus, the recent House of Lords report that was critical of the Bank of England was long overdue.
This creates a challenge. Unconventional and unlimited monetary and fiscal policies may have pulled the global economy back from the brink of a depression over the past year, but exit strategies carry risks, particularly if central banks are seen as being behind the curve, reacting to events.
The immediate focus is therefore on inflation. Which "p" is it? Will the recent rise in inflation pass through, persist or become permanent? At Jackson Hole, expect to hear the word "transitory" repeated a lot as central bankers use this to describe the rise in inflation. They are right. I don't think the present bout of inflation is permanent, as global competitive pressures and technology feed longer-term disinflationary pressures. Despite this, inflation may prove more than temporary and could persist for the next year or two, because of higher costs, firm oil prices, rising wages and companies boosting margins.
In the early 1990s I was among a small group of economists predicting the move to a low-inflation, low-rate world. The lesson from then is how the consensus was slow to adjust its thinking. The lesson for now is that the market may not be the best guide if inflation were to prove stubborn and persist. The reality is we don't know and thus gauging the balance of risks is key.
Part of the challenge in recent decades has not been the actions of central banks in difficult times, when they have been forced to ease. It has been in recoveries. Ideally, that is when rates should have been peaking at much higher levels. But that has not happened. Rates have stayed permanently low.
This year at Jackson Hole, the key question in the light of a recovering US economy and higher inflation is: does the Fed taper or tighten? Taper via reducing its asset purchases of US treasuries or signal that it may tighten via raising rates sooner than it is presently indicating, or both? Tapering seems more likely.
The Bank of England, meanwhile, continues to ease, buying gilts to reach its mammoth £875 billion quantitative easing target. It plans to only reduce these holdings once policy rates, now at 0.1 per cent, reach 0.5 per cent. It also unnecessarily owns £20 billion of corporate bonds.
With growth recovering and inflation persisting, the Bank of England should be opting for immediate, gradual and predictable tightening of monetary policy. My preference is to halt QE immediately, with a view to reversing it.
Jackson Hole is likely to be judged by how financial markets react. The trouble is they are not always the best guide to whether monetary policy is on the right trajectory.
Since the 2008 financial crisis, monetary policy has become the shock absorber for the world economy. A financial crisis partly caused by too low a level of rates and too much liquidity would be solved by even lower rates and more liquidity. This pandemic has continued this, even with fiscal policy playing a bigger role.
Monetary policy has fed asset prices inflation and exacerbated inequality within many western economies, including the UK, where financial assets and house prices have soared.
Having fed this problem without accepting any responsibility, it is important that central banks do not tolerate higher inflation now, as it would hit the poor and those on fixed incomes the hardest.
This article was published in The Times on August 14th 2021.
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