How to be a dove

Last week’s Free Lunch went out hours before the start of this year’s Jackson Hole symposium, the annual jamboree for the world’s central bankers, and all I could do was propose some difficult questions they ought to consider. By now, video recordings as well as the speeches and conference papers are available online, and I encourage Free Lunch readers to look them up. One of the blessings of current technology is that everyone can follow in nearly real time as the world’s best scholars and policymakers try to wrap their heads around a rapidly changing economy.

So what were the main takeaways? The highlight was, of course, Federal Reserve chair Jay Powell’s speech, which set out how the world’s most important central bank has decided to update its monetary policy strategy. The speech is worth reading closely. Not only does it commit the Fed to a more stimulative policy stance than its previous doctrine would have allowed. The reasoning behind the shift is also much more reflective and attuned to wider society — I am tempted to say more humanistic — than what we are used to hearing from central banks.

Powell has devoted much attention to the experience of marginal economic constituencies expressed at “Fed Listen” events around the country, and he and his colleagues will now formally treat the Fed’s employment mandate as a “broad-based and inclusive goal”. This recognises what Free Lunch has often insisted on: that macroeconomic policy must work for the margins of the labour market — the people who are hired last and fired first — or it will reinforce existing structural discrimination in the economy.

A few days after Jackson Hole, Powell’s colleague, Fed governor Lael Brainard, made this reasoning even more explicit in a follow-up speech at a Brookings Institution event on the Fed’s new framework. She said: “The longstanding presumption that accommodation should be reduced preemptively when the unemployment rate nears the neutral rate in anticipation of high inflation that is unlikely to materialize risks an unwarranted loss of opportunity for many Americans. The decision to allow the labor market to continue healing after the unemployment rate effectively reached [its estimated “normal” rate] supported a further decrease of 3½ percentage points in the Black unemployment rate and of 2¼ percentage points in the Hispanic unemployment rate, as well as an increase of nearly 3 percentage points in the labor force participation rate of prime-age women.”

In practice, the change means getting rid of the idea that some level of (un)employment constitutes a speed limit for the economy, unless inflation is actually becoming too high. That is a welcome change — and one that brings the Fed closer to its legal mandate. In a column this week, I argued that the same would be true for the European Central Bank which, unlike what many believe, does not only have a single mandate to combat inflation. The Fed will also now target the average inflation rate over time, rather than simply aim for 2 per cent in the medium term, regardless of how far off target it may have been in the past. In today’s circumstances that means tolerating higher than 2 per cent inflation for a period. Expect, as Brainard tells us to, “a process of opportunistic reflation”.

While the Fed is making an explicit dovish shift in its framework, all central banks have been forced into aggressive stimulus mode by the pandemic. The signs are plain (see the eurozone’s record-low service price inflation, below) that aggregate demand has suffered from the lockdowns even more than supply capacity. That raises the question how any additional policy stimulus will be delivered — that is to say, the question of monetary policy instruments.

Several participants at Jackson Hole touched on one aspect of this challenge. A dramatic rise of uncertainty because of the pandemic, and the “scarred beliefs” that now include the possibility of previously inconceivable shocks, are a drag on growth and mean central banks have to run harder just to stand still. (On top of the pandemic, economies have to contend with rising political uncertainty. As Robin Wigglesworth explains, markets price in heightened volatility in the run-up to the US presidential election.)

Another aspect is this: if central banks have struggled to be as inflationary as they were supposed to, how are they going to be able to be more inflationary still? There is a lot of confidence in the effect of “forward guidance”, that merely saying one aims for a more inflationary policy itself stimulates growth and price growth. But if central banks are perceived as not achieving their previous target, will people believe they can reach a more ambitious one? It could be even worse: one Jackson Hole paper, presented by Yuriy Gorodnichenko, suggests that raising inflationary expectations could lead to a contraction in economic activity, because consumers may see inflation as something bad for the economy.

Guidance is not reliable without tools that can act directly on aggregate demand — and central bankers willing to use them. Yet there is a disappointing paucity of public discussion about this. An important exception at Jackson Hole was Bank of England governor Andrew Bailey, whose speech offered new thinking about countercyclical balance sheet policy. Because asset purchases by the central bank can have particularly strong effects when times are bad, he suggested, it is worth considering giving it a higher priority as a regular monetary policy tool rather than treating it as the last resort when short-term policy rates lose traction on the economy.

But on the question of whether negative rates are useful, the debate has gone stale. Only the BoE has shown some flexibility, now stating negative rates are in the toolbox (but not to be used now). The Fed, however, is refusing to consider negative rates even as it commits to a more expansionary monetary strategy. And outside Japan, no other major central bank seems at all ready to contemplate targeting long-term interest rates directly (or “yield curve control”).

The dovish shifts are welcome. But central banks must will the means as well as the right ends.

Other readables

  • Read my colleague Gregory Meyer’s in-depth reporting from farmland New York State on the travails facing the zero-carbon energy transition on the ground.

  • I review a refreshingly unconventional take on what causes innovation — or the lack of it — by economics Nobel laureate Edmund Phelps and his collaborators.

  • Last month I wrote about Belarus’s economy, including its successful IT sector. James Shotter writes that this success is now threatened by the government’s heavy-handed crackdown on protests and the internet shutdowns that go with it.

Numbers news

  • The eurozone has unexpectedly slipped into deflation. Most worrying is the record-low rate of price growth in services, which largely reflects homegrown price pressures — or their absence. While the pandemic was first of all a supply disruption, it is now clear that the demand shortfall has been even greater.

  • France is announcing its economic recovery package today; Ben Hall offers a preview.

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