By Michael Every of Rabobank
Jackson Hole: "Does my R* look big in this?"
The Jackson Hole central banking symposium has been running at its Wyoming venue since 1981. As such, it spans almost the entire neoliberal economic era in which central banks have been independent rockstars, not the boring civil servants following a political lead of prior decades. Ironically, 2023’s event, titled "Structural Shifts in the Global Economy," pointed out an intellectual hole at central banks and their sudden lack of power, prompting look-in-the-mirror criticism. In particular, the focus was on the size of their R*s now politics matters again – that’s as President Biden released a video about tbuilding middle-class bottoms up and out as the American dream, rather than letting things trickle down.
R* is the term for the presumed ‘neutral’ short-term interest rate expected when an economy is at full strength and inflation is stable. That sounds obscure, but it matters hugely now rates are no longer at 5,000-year lows. R* tells us where rates will peak and are likely to stay close to. The valuation of many tens of trillions of financial assets depends on this; more so because a huge part of that asset pile is still hoping we will soon go back to 5,000-year low rates. Yet ‘the Hole’ saw central banks say the global backdrop has changed, and imply that so have their R*s.
FOMC Chair Powell’s speech, ‘Inflation: Progress and the Path Ahead’, said: “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.” On R*, he noted, “the supply and demand dislocations unique to this cycle raise further complications... there is evidence that inflation has become more responsive to labor market tightness than was the case in recent decades,” leading to uncertainty. Especially when the White House whiteboard is talking about surging investment and rising middle-class wages.
ECB’s President Lagarde’s speech, ‘Policymaking in an age of shifts and breaks’, was not a paeon to zero-hour contracts as would have been the case four years ago. Instead, she quoted Kierkegaard’s “Life can only be understood backwards; but it must be lived forwards,” who aptly wrote ‘Fear and Trembling’. She noted three structural shifts: (i) “profound changes” in the labour market; (ii) the energy transition; and (iii) geopolitical shocks, and argued that whether these will prove permanent is unclear, “but it is already evident that, in many cases, their effects have been more persistent than we initially expected.” As a result, pre-Covid GDP models where swings in demand are most important “may no longer be appropriate [as] we are likely to experience more shocks emanating from the supply side.” She’s completely right there: our models are wrong.
Moreover, these larger relative price shocks can be transmitted more easily because they act as an “implicit coordination mechanisms vis-à-vis their competitors” for firms who are “not only more likely to adjust prices, but also to do so substantially.” That’s the Sellers’ Inflation economists are busier explaining doesn’t happen than looking at the political-economy of why it does. Meanwhile, tight labor markets mean “[when] workers have greater bargaining power, a surge in inflation can trigger “catch up” wage growth which can lead to a more persistent inflation process.”
The only responses, she argued, are: clarity, flexibility, and humility. Central banks have to stress that rates will stay higher for longer, show flexibility in analysis, and “be clear about the limits of what we currently know and what our policy can achieve.”
BOE Deputy Governor Broadbent’s speech, ‘The economic costs of restricting trade: the experience of the UK’, (spuriously) argued there’s no evidence that less globalised trade is more effective at protecting from economic shocks. It also underlined that unwinding second-round energy-price effects in wage inflation will not be as rapid or as marked as their emergence. As a result, “policy will probably have to remain in restrictive territory for quite some time yet.” He also pondered if “perhaps the wage Phillips curve is convex – falls in unemployment from low levels have more powerful effects on inflation than those from higher levels. Or maybe these two underlying drivers --the worsening terms of trade and the tight labour market-- have interacted in some way, each amplifying the effect of the other, i.e. there’s a multiplicative term in the Phillips curve.... in the face of these uncertainties, setting monetary policy becomes a good deal more complicated.” And just after he spoke, UK air-traffic control failed on a Bank Holiday weekend.
In short, all of the above speeches answered the question “Does my R* look big in this?” in the positive, which is never well-received: we can expect markets to be unhappy too when they twig.
At the short end of the yield curve, central banks are going to err on the side of caution via higher for longer: yesterday’s $45bn 2-year US auction cleared at 5.02%, the highest since 2008. Further down the curve, if central banks are right about the global backdrop changing, inflation is not going back to 2% without a larger R* to sit on it. However, if they are wrong, keeping rates high is likely to risk deflation, in which case they will have managed to tear the economy a new R*, BOJ style. Then we will see what the White House whiteboard says.
Worryingly, central bankers have been wrong for decades. Indeed, in a moment of delicious pathetic fallacy, when they went on a hike at Jackson Hole with some economists this weekend, they were reportedly forced to retreat due to a summer downpour involving hailstones(!) Talk about “not having a playbook,” as Lagarde out it, or, as Powell did, “navigating by the stars under cloudy skies.” I’m only listening to central bankers now because they are willing to say they have been wrong and are guideless, which is the first step towards wisdom.
However, market forecasts of a return to 2% CPI *and* lower interest rates are still not accepting that their demand-side DSGE models are wrong, and are assuming central banks are in control when they just made it clear that they aren’t, and don’t pretend to be! Even the central bank markets were most sure was always in control, the PBOC, is looking increasingly powerless - and note the rally and sell-off in Chinese stocks yesterday.
Regardless, many economists and analysts will insist on a small R* with no deflationary downside. That’s the ‘safe’ choice: to forecast a large R* is to bring down calamity; to forecast a small R* is to imply calamity being brought down on us. Even safer is not to read any of the Jackson Hole speeches, nor think about Sellers’ Inflation, changes to labour markets, deglobalisation, geopolitics, nor the energy transition, and just focusing on the ‘positives’, i.e., neither Powell nor Lagarde backed a September hike. (Oops! Mester and Holzmann both then did.)
There are some central banks who prefer to avoid serious thinking too. We get to hear from RBA soon-to-be Governor Bullock today, but as things stand the Reserve Bank implies it may stop hiking at just 4.1% and then lower rates soon(ish), even as Melbourne houses already sell at auction for a million dollars over the asking price. On which, I recall Scottish comedian Billy Connolly noting that because we can’t see our own backsides, we choose somebody else’s and project that as a mirror of ours: except we cheat by choosing a much smaller one than our own.
On structural changes in general and property in particular, what we didn’t get from Jackson Hole was talk of the need for multiple R*s for different sectors as part of a policy response, which is where I think we head in time via rates hikes and acronyms like QE for the ‘right kind of investment’, or rate cuts and acronyms like QT for the ‘wrong kind’. If you accept everything else they said, this shift will follow.
Of course, that will need a ring-fenced economy, as normal before Jackson Hole began to run, and political ideology to match. Central banks, looking for a new playbook or not, aren’t ready to back *that* kind of shock until politicians are – but some of them are starting to mumble it.