The Overlooked Lessons at Jackson Hole

Fed Chair Jerome Powell virtually delivered his much-anticipated speech at the Kansas City Fed’s annual Jackson Hole central banker-fest Friday. As expected, he pretty overtly hinted the Fed is heading towards slowing quantitative easing (QE) bond purchases—i.e., “tapering”—this year. Loads of pundits see QE as crucial to stocks and the economy, and many have hyped this proclamation as a watershed moment. But, no shock to us, the news didn’t seem to faze markets one bit. In our view, this is further evidence pundits’ Fed focus is overdone. Central banks simply aren’t as powerful as many believe—worth remembering amid calls to give them even more responsibilities.

In past communications, the Fed has tied changes to monetary policy to the state of the economic recovery. Powell often referred to the need for “substantial further progress” before even considering any adjustments. His speech today implies that hazy distinction has been hit, with most coverage focusing on this particular section:

My view is that the ‘substantial further progress’ test has been met for inflation. There has also been clear progress toward maximum employment. At the FOMC's recent July meeting, I was of the view, as were most participants, that if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.^[i]

In Fedspeak—the purposefully vague and nebulous communication used by central bankers—this is about as clear a taper signal as you will get. The market reaction, though, amounted to a yawn. 10-year Treasury yields ticked down to 1.31% from 1.34% while US stocks rose 0.9% on the day, closing at a fresh record high.^[ii]

Most fixation on Powell’s Jackson Hole speech stems from the bizarre notion stocks’ rise since last March was due largely to Fed action—particularly QE. In our view, this is vastly overstated. Some of the Fed’s actions may have helped calm investors last March, but other “emergency” moves may have stoked panic, too. As for QE, it just isn’t the economic boost many presume. As we have argued often, QE is an economic sedative, not stimulant. Banks borrow short term to lend long. The Fed’s buying long-term debt lowers long-term interest rates, and with short-term rates already near zero, the result is a smaller gap. That makes lending less profitable, discouraging banks from taking on the risk of making loans.

In our view, markets’ non-reaction really shouldn’t shock. Even if you disagree with our QE views, pundits parse every Fed official’s words routinely. We believe efficient markets have heard taper chatter since the year’s start—noise that has only increased lately. Those taper discussions sapped surprise power by the time Powell delivered his address today—forward-looking markets already reflect the information.

In our view, the obsession with central banks has lately spun even more out of control—in ways that risk politicizing monetary policy. For example, some pundits think central bankers should account for climate change in crafting monetary policy. Fed Governor Lael Brainard addressed the topic in a March speech, positing climate change could increase financial system vulnerabilities—necessitating Fed investment in research and tools to address the potential risks. After its recent strategy review, the European Central Bank (ECB) paid lip service to fighting climate change.

But expanding the Fed’s responsibilities has more downside than upside, in our view. The Fed exists to serve as lender of last resort to banks in a crisis. Congress added a “dual mandate”—to foster maximum employment and stable inflation—in the 1970s, after former President Richard Nixon strong-armed former Fed head Arthur Burns into holding interest rates artificially low early in the decade, contributing to high inflation. But the Fed’s record on these measures isn’t stellar. It failed to act as lender of last resort amid runs in 2008. After announcing an inflation target of 2% y/y in 2012, the Fed spent the next 8 years undershooting it. (They updated their strategy last August.) Moreover, the Fed lacks a crystal ball. As transcripts from 2008 meetings show, most Fed officials completely whiffed on diagnosing the financial crisis. Just two weeks after Fed decisions forced Lehman Brothers to fail, former Fed chair Janet Yellen—then San Francisco Fed President—joked about the recession’s chief effects being dwindling country club memberships and deferred plastic surgeries. Fed governors closed that gathering debating whether their policy statement should characterize them as watching economic developments “closely” versus “carefully.” They seemed broadly unaware the worst financial panic since the 1930s was underway.

Given their ineffectiveness with hitting inflation targets and economic outlooks, why add another target—especially one far removed from the Fed’s purview? Knowledge of climate science, itself an evolving field, isn’t in a central banker’s wheelhouse, last we checked. Nor is knowledge of the various technological solutions to emissions and electricity generation. It also isn’t clear how Fed actions could impact the environment or climate. The Fed’s tools are designed to address monetary conditions that have a downstream impact on macroeconomic conditions. It lacks tools to address things at a sectoral or industry level directly, even if it wanted to.

Some suggest the Fed and other central banks should add environmental criteria for potential QE asset purchases or future policy actions—meaning it wouldn’t buy bonds from firms like fossil fuel producers. Lots of folks suggest this would make their funding more costly—and curtail their ability to expand production, etc.—unless they went greener. But this implies central banks are the market’s most important participant—a fallacy, in our view. Even if central banks decide to favor a certain industry or sector, the “losers” won’t necessarily be cut off from markets. As yields rise, private investors may see a buying opportunity and step in, offsetting that pressure.

But regardless of the practical impact (or lack thereof), this would look like unelected officials picking winners and losers. That is politicians’ stock and trade. The more the Fed does this, the more it invites political interference in monetary policy. That is dangerous. Revisit the Nixon-era lessons. The Fed has never been totally independent, but it generally has enough freedom to implement policy without worrying about what it does to politician XYZ’s election chances. The more it injects political choices into policy, the less likely that holds in the future.

There is no clear sign the Fed will add politicized factors to its purview. But we generally subscribe to Occam’s razor—simpler is often better. We fail to see how adding more complexity to the Fed’s job would lead to better monetary policy.