At this time every year, the Kansas City Fed hosts their Economic Policy Symposium in Jackson Hole, Wyoming. It is a meeting of economic minds like no other, with central bankers from the developed and developing worlds, academics, and executives gathering to discuss the major issues of the day.
The highlight of this year’s meeting comes today, when the two most powerful voices in the global economy will be heard. Fed chair Janet Yellen will speak this morning, followed by ECB President Mario Draghi this afternoon. Central bankers are not usually appointed for their entertainment value and have a tendency towards wonk-speak of the highest order, so what they say may sound like gobbledygook to a lot of people, but it comes at a critical time and has the potential to affect us all.
We live in an age where it could be argued that the deliberations and decisions are more impactful than ever before. Following the recession, politicians around the world, for a variety of reasons and regardless of their political leanings, decided not to pursue fiscal policies to reflate their economies.
In politics, “stimulus” became a dirty word, and the necessary task of promoting growth was left to central bankers. Loose monetary policy became the norm, with central banks buying huge amounts of bonds and other assets with money created out of thin air to flood markets with liquidity.
The theory was that banks awash with cash would lend it out to businesses, encouraging growth. The reality has been less than perfect, with investment continuing to lag as asset prices were driven up by speculation and with bonuses at banks creeping back up, while growth has remained low for a recovery.
That, it seems, was the price we had to pay to avoid dropping back into recession. There was one other downside to those asset purchases, known as quantitative easing (QE). At some point, the central banks would have to work out what to do with that massive portfolio of assets that they had built up. That point is rapidly approaching.
In most people’s reckoning, QE was, despite its imperfections, both necessary and effective. The EU, which resisted the idea at first, struggled, dropping back into negative growth on several occasions before the ECB began buying bonds. Once they were on board, however, global growth began to pick up, and is now at the point where it probably no longer needs further monetary stimulus.
The problem, of course, is that you run the risk that when you reverse a policy with such big effects, you will, logically, induce the opposite effect. The global economy is recovering, but doesn’t look like overheating in any way, so the cooling effects of asset sales at this point could prove disastrous.
So, you might say, why not just hold onto those assets? What does it matter if the Fed and EU both have giant balance sheets? Well, there are a couple of reasons.
The amount of borrowing in an economy has a natural limit, and buying massive amounts of bonds and removing them from the market makes the remaining debt scarcer, and therefore more valuable. When the price of a bond rises, its effective interest rate, or yield, falls.
That is why interest rates have remained extremely low throughout the recovery, and that poses a problem. Eight years have passed since the recession, and with every year the likelihood of another economic downturn, quite possibly caused by some random, unforeseeable event, increases. When that comes, a monetary response will be required, and that is almost impossible to do effectively when the 10 Year is yielding around 2%.
The second reason, tied in with the first but somewhat more esoteric, is that what central banks are doing, by design, is distorting the world’s most fundamental markets. When there is one huge buyer setting prices, and therefore rates, there is no way of knowing where the markets value the sovereign debt in developed nations, which are the benchmarks for all other investments. We may suspect that both bonds and stocks are being pushed into dangerously overbought territory, but with no benchmark against which to judge them, there is no way of knowing.
At some point, then, the world’s central banks must reverse course. There has been a lot of media focus on small changes to existing policy such as changes in the rate of purchases or small changes to short term interest rates, but very little discussion of the big change yet to come when the whole thing is reversed.
That discussion could become a lot more prominent today if Yellen and or Draghi confront their dilemma and use their speeches at Jackson Hole to lay out their plans. If they do so, the market reaction may not be as sharp as it would be to something like an interest rate announcement, but the implications would be widespread, long-lasting and of huge consequence.