Janet Yellen flip-flops in Jackson Hole

The Federal Reserve’s credibility has taken a few knocks in recent years. Back in the early 2000s, when Alan Greenspan was chairman, confidence among the American public often exceeded 70%, but things have changed. In April this year, today’s chair, Janet Yellen, was found by Gallup to have the confidence of little more than half that, with a larger number having little or no confidence in her at all. The fall from grace is hardly surprising: since the financial crisis in 2007 the Fed has generally looked incompetent.

For starters, take their grasp of where the economy is heading: in 13 of the last 15 years their projections have overestimated actual growth; it will happen again this year. On inflation they have been only marginally better. On unemployment, they have been more successful, but for the wrong reason: unemployment has been falling more because of a shrinking labour pool than because of an increase in employment. To be fair, most mainstream economists have had the same unjustified confidence in the government’s response to the Great Recession, but that doesn’t change the fact that the Fed ‘s forecast has been poor. That they may have deliberately been overstating their trust in the economic recovery for political purposes is another matter, we continue to believe that more a more realistic assessment of the economy will emerge once Hillary Clinton is safely installed in the White House and Janet Yellen is sure of another term as Fed chair. The Fed’s interest rate policy has followed their economic forecasts: a year ago they were predicting that their benchmark rate would already be above 1.5%, but the reality of a stalling economy got in the way of those plans and they haven’t yet managed to get it above 0.5%.

This weekend the Federal Reserve met for their annual symposium in Jackson Hole, where once again the subject which economists and traders were most interested in was whether there were any signs as to when the next rate hike is coming. September? December? There was little in the way of concrete guidance, though at the end it seems most economists saw a slightly hawkist tint to proceedings. Anyway, it is not that important, the message that rates are not going anywhere near historic levels has been received. More interestingly, but afforded much less attention, was the fact that the Fed performed yet another policy flip-flop: Yellen admitted to a change of heart with respect to the Fed’s balance sheet, which was so dramatically ramped up during the QE experiment. Originally, she had a goal of reducing the balance sheet before interest rates were raised, but that policy has now been abandoned. Of course this is because the FED knows that they can’t achieve it: if they are to be credible in their promise that more rate hikes are just around the corner, then it is obvious to everyone that they will not manage to even start reducing the balance sheet in advance. Remember, they have not even stopped re-investing interest and principal payments they receive on the $4.5bn government bonds they own. So a policy change was inevitable. Nonetheless, it is a dramatic change: a de-facto admission that the unwind of QE is indefinitely on hold.

Recognising that interest rates are not going to be much higher than they are now when inevitable the next recession hits, thus leaving interest rate cuts generally unavailable to stimulate the economy, Yellen also touted QE as the prime weapon in the Fed’s arsenal. It is amazing to think how QE was invented in Japan as recently as 2001, and first tried by the Fed in 2009. Less than a decade later it has become a mainstream policy tool, despite no-one having demonstrated that it is in fact possible to unwind such massive market interventions without triggering a crash. Yellen said that $2bn QE was available to combat a possible future recession, but that number looks small. US government debt is already more than twice the pre-2007 level, leaving Washington much less able to stimulate the economy by fiscal means. And in the Great Recession QE was accompanied by rate cuts from 5.25% to 0.25%. It is obviously not credible to think that a much smaller dose of QE will manage to save the day all on its own.

Central banking is in uncharted waters. To keep credible, officials have to have to appear to have a plan, but the truth is they have no clue when the economy will turn and no clue what to when it does and they are called upon to act. So we can prepare for many more policy revisions and flip-flops in the years to come.

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