Central bankers have dug themselves into a Jackson Hole

Federal Reserve Chair Janet Yellen and European Central Bank President Mario Draghi walk together during the Jackson Hole Economic Policy Symposium in 2014. (AP Photo/John Locher, file)

The meeting of central bank governors at Jackson Hole in Wyoming that started on Thursday could be the most critical since the financial crisis unleashed the banks’ escalating experiments with unconventional and unprecedented monetary policies.

At the very least, the US Federal Reserve Board’s chair, Janet Yellen, might provide an insight into the likelihood of a (modest) rise in US official rates before the end of this year, a signal with the potential to generate some significant disruption in financial markets.

It may do neither of those things.

The theme of the meeting is: “Designing Resilient Monetary Policy Frameworks for the Future.” That might suggest some esoteric discussions about how to deal with some distant threat to economies and financial systems rather than the stagnation and fragility of the world economy and financial system today.

While it is unlikely that Yellen will explicitly signal a US rate hike in September or, if there is to be one, more likely December, the nuances of her comments will be pored over by analysts and could have a significant impact on markets driven and inflated by the ultra-low rate environment.

Recent public commentaries by the some of the more influential Fed members have indicated a strengthening of the hawks (those that lean towards a rate rise) among them.

Given the demonstrated sensitivity of the Fed to financial markets and its stated desire not to take them by surprise, the Fed watchers believe that, if there is to be another 25 basis point rise, it will come, as it did last year, in December and will be clearly signalled in advance.

Any rise, or indeed continuing inaction by the Fed, has implications well beyond the US.

Financial markets and financial asset prices across the globe have been distorted by the actions of central banks and the Fed, given the primacy of the US economy and currency, is the pivotal player.

The federal funds target rate of 25 to 50 basis points has forced Europe and Japan into negative rate territory to try to weaken their currencies against the US dollar and improve their competitiveness; it has inflated bond and equity prices; it has encouraged a dramatic increase in emerging market US dollar-denominated debt; it has broken down historic correlations between asset classes and it has destroyed the concept of risk premia.

What the central banks haven’t been able to do is to generate meaningful and sustainable growth in the developed economies, although at least the US economy has been generating modest growth, reasonable decent job creation and the first tentative signs of inflation.

What has become apparent, eight years after the crisis, is that there are limitations to monetary policy, no matter how unconventional, and that central bankers aren’t omniscient or omnipotent.

The reliance on monetary policy alone to reignite growth has been a failure and potentially a dangerous one by encouraging and, indeed, forcing increasing levels of risk-taking for decreasing levels of return by institutions and individuals. It is also throttling the profitability and the ability to generate organic capital of banks, insurers and pension funds.

Citi’s global head of credit products strategy, Matt King, recently summed up the current state of affairs: “Most doctors and even patients know that, when a course of drugs seems not to be working, you don’t simply keep on doubling the dosage. This applies particularly when the patient, if no longer as sprightly as they used to be, is nevertheless doing more or less fine.

“The side effects of such a course are more likely to kill than to cure. Yet this is what central banks now seem intent on doing. They have too much invested in their models to consider changing them in our view.”

In talking about the design of future monetary policy frameworks, the central bankers conveniently circumvent the question of whether the supercharging of conventional monetary policies is the cause, rather than a response to, the continuing global economic malaise.

Have the policies they’ve followed since the crisis solved structural problems within the global economy and financial system or simply deferred and exacerbated them?

A lot of central banks speeches this year have ducked the issue of whether the ultra-low, even negative-rate, policies they have pursued are a factor in the failure to reignite investment and growth in real economies.

Instead, they look to other influences which may well be real.

There is a view that the aftermath of the financial crisis has coincided with long-term trends of ageing populations in the advanced economies, the rapid deployment of new technologies and a new phase of globalisation that depresses economic and productivity growth rates and job creation.

If the post-crisis stagnation of developed world economies relates to long-term structural factors, then the central bankers would need to rethink their approach and redefine what new level of rates would be appropriate to balance savings and investment.

The bankers are also debating whether inflation targets ought to be altered and whether inflation is still a relevant target.

That’s where the discussion about targeting nominal GDP (which Nick Xenophon has latched onto) has come from and why the theme at Jackson Hole is about monetary policy tools for the next downturn rather than how to extricate themselves from the current dysfunctional settings.

As Matt King says, markets and the relationships between them have been badly broken by the monetary policies pursued since the crisis, overwhelmed by the ever-swelling tide of central bank liquidity. If there’s more of the same, he forecasts, there will be “ever more hand-wringing over a stagnating global economy” and ever-greater dysfunction in markets.

If one steps back at looks at the current financial market settings, it would be possible to argue that the central banks have created a situation that has apparent binary outcomes but ultimately leads to the same conclusion.

If they maintain the current low-to-negative official rates and central bank balance sheet expansions they will continue to inflate financial asset values and deflate returns — until the system breaks. If they were to start normalising monetary policies at a reasonably quick pace, there would almost certainly be a very significant sell-off of financial assets and probably recessions.

They are trapped in a conundrum of their own devising and those new monetary policy tools to fight future crises that the central bankers are searching for at Jackson Hole may yet be required to deal with the continuing legacy of the last crisis and their own contributions to it.