Bernanke At J-Hole: What He Will Say And What He Won't

With Draghi stepping aside, the headliner can shine and while Goldman does not expect Chairman Bernanke's speech on Friday morning, entitled "Monetary Policy Since the Crisis", to shed much additional light on the near-term tactics of monetary policy beyond last week's FOMC minutes; their main question is whether he breaks new ground regarding the Fed's longer-term strategy. An aggressive approach would be to signal that the committee is moving closer to the "unconventional unconventional" easing options that Goldman has been ever-so-generously advocating for months, although even they have to admit that expectations are that any moves in this direction will be gingerly.

Via Goldman Sachs:

Another year, another wait for Chairman Bernanke's Jackson Hole speech. Just as in 2010 and 2011, markets are eagerly anticipating his appearance on Friday morning at 10am EDT for clues to what the FOMC might be planning at its September meeting and beyond. Today's comment discusses our expectations in Q&A form.

Q: Do you expect Bernanke to provide much additional information about the near-term monetary policy outlook. In particular, will he provide new information about whether the committee will embark on QE3, i.e. start another asset purchase program?

A: No. While we expect his speech to be consistent with a high probability that Fed officials will ease monetary policy further, this would not add much new information following the very dovish FOMC minutes released last week. The question of whether Bernanke will include a list of the easing options in his speech--which was very much on the market's mind in the run-up to the 2010 and 2011 Jackson Hole symposia--is also less important. This is because, unlike in 2010 and 2011, when the symposium occurred before the minutes of the August FOMC meeting were released, the August minutes have already been released and we already have such a list in hand this time. It includes (1) a lengthening and/or reformulation of the forward guidance, (2) a return to asset purchases and Fed balance sheet expansion, and further down the list, (3) a cut in the interest rate on excess reserves, and (4) a "funding for lending" program along the lines of that introduced by the Bank of England recently. If he chooses to go through this list again, we would expect him to hew closely to the formulation in the minutes, without a clear indication of the form or timing of any easing.

Q: So what will he say?

A: Recognizing that it is difficult to forecast free-form speeches, Bernanke's title "Monetary Policy Since the Crisis" suggests that he might take a broad "lessons learned" approach. If that is correct, here are a number of key lessons that might be included:

  1. Financial crises and housing downturns have large negative effects on aggregate demand. Therefore, monetary (and fiscal) policy need to be highly accommodative for a number of years to keep inflation from falling to undesirably low levels and to help reverse the increase in unemployment.
  2. Some well-worn rules of thumb of macroeconomics don't apply when the economy is stuck at the zero bound. In particular, even a very large increase in the central bank's balance sheet or the monetary base is not necessarily a harbinger of higher inflation. This is contrary to the predictions of many well-known economists back in 2009.
  3. The zero lower bound on nominal interest rates is a more serious obstacle to making monetary policy sufficiently accommodative than many economists--including Ben Bernanke--had thought prior to 2007. Although forward guidance and changes in the size and composition of the Fed's balance sheet can still provide stimulus, gauging the effects of unconventional easing is more difficult, and it therefore tends to be undersupplied relative to a situation in which these effects were estimated with certainty.
  4. Unconventional Fed balance sheet policies work mainly through the asset side (i.e. the so-called portfolio balance effects) rather than through the liability side (i.e. the amount of bank reserves in the system). In particular, the available evidence suggests that Operation Twist (which involved no lengthening of the Fed's balance sheet and no increase in bank reserves) seems to have been at least as effective in reducing bond term premia and easing financial conditions as QE2 (which involved both of these). This suggests that it was really the duration removal (which was broadly the same under QE2 and Twist 1) and therefore the portfolio balance effects that mattered.
  5. Sustained periods of high unemployment can result in "hysteresis"--a higher structural rate of unemployment and a decline in labor force participation. This complicates monetary policy. On the one hand, after hysteresis has set in, it implies less room for monetary easing than one might think on the basis of the pre-crisis output and employment trend; on the other hand, before hysteresis has set in, it implies an added benefit from accommodative policies, relative to normal times. (This point was a key theme of Bernanke's speech at last year's Jackson Hole symposium.)
  6. Inflation expectations are even more "anchored" than economists thought before the crisis. Despite a very large output gap, inflation has been fairly stable at levels only slightly below the Fed's 2% target. This provides a strong refutation of a simple "accelerationist" inflation model, in which this year's inflation is equal to last year's inflation plus a term that depends on the level of the output gap. This implies that there is less risk of outright deflation than one might have thought before the crisis. However, note that the anchoring of expectations cuts both ways; there is less risk of deflation, but also less risk of inflation if the central bank does oversupply monetary stimulus.

Q: How could Bernanke break new ground relative to these lessons, which he has discussed before?

A: The most obvious way to break new ground would be to open the door to "unconventional unconventional" easing, which could include a nominal GDP target or an Evans-style commitment to easy policies until the economy has regained a bigger share of the lost output and/or employment. The August FOMC minutes hint at growing appetite for this approach, saying that an extension of the rate guidance "…might be particularly effective if done in conjunction with a statement indicating that a highly accommodative stance of monetary policy was likely to be maintained even as the recovery progressed."

A detailed discussion of unconventional unconventional easing by Bernanke is not our baseline expectation. The sentence in the minutes quoted above comes from a discussion by the full set of 19 "FOMC participants" (i.e., voters and nonvoters), which includes some known enthusiasts for such an approach--i.e., Presidents Evans, Rosengren, and Williams. However, if Bernanke did signal greater openness to unconventional unconventional easing, this would be quite a strong signal, not least because he described pushing inflation above target in a bid to speed up the recovery as "reckless" not too long ago. Such language would undoubtedly have a significant market impact.

Q: What is your current forecast for what the Fed will do over the next few months?

A: At a minimum, we expect an extension of the forward rate guidance to "mid-2015" at the September 12-13 FOMC meeting. We also expect an eventual return to QE, although in terms of timing we believe that either December or early 2013 is still more likely than September. There are two reasons why we have not changed this view despite the dovish August minutes:

  1. We do not read the minutes as definitive in terms of the form and timing of additional easing. With respect to the form, the FOMC clearly views a lengthening of the guidance as a form of monetary easing, so it is not the case that the phrase "…many members judged that additional monetary accommodation would likely be warranted fairly soon…" necessarily implies QE. And with respect to the timing, the term "relatively soon" presumably encompasses not just the September 12-13 meeting but also subsequent ones.
  2. The tone of the data has clearly improved a bit since the meeting. Our Current Activity Indicator now stands at 1.5% for July, vs. 1.1% in June. Moreover, we estimate that Q3 GDP is on track for a 2.4% annualized gain versus an advance estimate of 1.5% for Q2.

However, a return to QE in September is clearly possible if the upcoming data, especially the August employment report released on September 7, fall short of expectations or if financial conditions tighten again--e.g., in the wake of any disappointment around the European situation and the ECB meeting on September 6.

Jan Hatzius