Jackson Hole: At the mountains but not out of the woods

Much attention centred on the reaffirmation of hawkish stances from key speakers, in particular Fed chair Jerome Powell and ECB executive board member Schnabel, however, broader discussions gave useful insight into some key issues that participants see impacting the outlook for the economy and policy.

In his opening remarks, Powell offered three lessons from the past forty years of monetary policy: one, that central banks can and should take responsibility for keeping inflation low and stable; two, that current high inflation can feed into persistently higher expectations; three, that any delay in bringing high inflation rates down would worsen the pain of ultimately getting the job done. It was a sobering reminder to market participants that whilst recent inflation indicators show some signs of reprieve, central banks are likely some way off of declaring victory.

His remarks set the tone for the remainder of the symposium, the theme for which was titled “reassessing constraints on the economy and policy”, with speakers reviewing recent trends in labour markets, productivity, the influence of fiscal regimes on inflation and more broadly the implications of shifts in several structural factors that have previously been important tailwinds in the Great Moderation era of low and stable inflation.

An overarching takeaway from the talks was that the policy trade-off has worsened. Central bankers are rightly concerned of the risks that current high levels of inflation could become self-reinforcing, via higher inflation expectations of businesses and households. If such a de-anchoring occurs, the process of bringing expectations back in line with central banks’ inflation targets will likely be a painful one.

The scope for lax fiscal policy has also reduced. There was a time in recent years when more emboldened fiscal policy was cited as a possible route out of the low growth and low inflation nexus that many developed economies had experienced since the GFC. The fiscal splurges of the pandemic, necessary to bridge activity shortfalls during lockdowns, have left governments with weaker finances and likely played their part in stoking elevated inflation. By the estimates of one paper presented, inflation in the US is 4% higher than it would have been without pandemic fiscal stimulus. As speakers at Jackson Hole noted, ongoing fiscal laxity could pose further upside risk to trend inflation and ultimately challenge the credibility of inflation-targeting monetary policy.

All of which suggests the policy landscape is shifting away from the era of the “central bank put”: an environment of policy asymmetry where markets could rely on central banks to act gradually to tighten policy as economic expansions progressed but aggressively at the first sign of weakness. That environment provided a useful backstop to equity markets, rewarding a “buy the dip” mentality, whilst also establishing the role of government bonds as a source of portfolio insurance. If the year-to-date softening activity and labour market indicators turns into a more pronounced downturn, markets may not be able to rely on central bank support to the same degree as previously if inflation readings remain stubbornly high.

In the immediate aftermath of Jackson Hole, key speakers have been keen to reaffirm their commitment to bringing inflation down. More generally, a key takeaway from this year’s symposium is that policy trade-offs have likely worsened: after three decades of benign economic conditions underpinned by the tailwinds of globalisation, technology and a deepening global labour pool, supply curves are steepening, with upside inflation risk now a constraint of both monetary and fiscal policy

From the monetary policy perspective this brings an end to the previous policy asymmetry – whereby markets relied on central banks very gradually tighten during economic expansions but to ease aggressively in downturns, which effectively provided a backstop for markets in recent crises. Consequently, we may expect a return to more compressed cyclical swings and elevated economic volatility, feeding through into interest rate uncertainty.

Implications for interest rates can be split between the outlook for cash rates and the term premium demanded for longer-dated bonds:

• Whilst nominal rates are almost certainly higher, it is less clear that pandemic impacts have shifted the equilibrium level of realinterest rates; continued low productivity growth, constrained demographic profiles and elevated debt levels are all factors that are thought to constrain the outlook
  
  
• but there are reasons to think a shifting regime could push required term premia higher (greater cash rate and inflation uncertainty)

Reduced room for policy asymmetry could also mean that the positive shift in equity-bond correlations that has taken place this year persists, reducing the diversification benefits of government bonds as cheap portfolio insurance, which means real assets and diversity in allocation is even more valuable. This has important implications for multi-asset portfolios:

• A serious reappraisal of investing in ‘risk-free’ government bonds, and their use as unconditional portfolio insurance
  
  
• A greater focus on a balanced portfolio with compensation for a range of risk factors, in particular sufficient real assets whilst being well diversified across asset classes and geographies.

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