The resort of Jackson Hole in Wyoming is one of the best places in the US for fishing and mountain hiking. Among the business and banking fraternity, it is mainly known thanks to the annual conference held there by the US Federal Reserve, the Jackson Hole Economic Policy Symposium. At this year's conference, due to open at the weekend, attention will naturally focus mainly on the speeches of two people: Federal Reserve chair Janet Yellen, and European Central Bank President Mario Draghi.
The question faced by Yellen and Draghi is a big one, and they themselves may not have a full answer to it: should the Federal Reserve accelerate, and the European Central Bank start, the sale of the huge inventory of bonds, to the value of trillions of dollars and euros, accumulated over the years from the policy of "quantitative easing" - a kind of safety mechanism.
The perplexity over this matter is considerable, and it can be argued that the senior officials at both central banks have not been trained to deal with the questions arising from an exit from quantitative easing. Moreover, those officials, including the heads of the central banks, have to decide not only how to act, but what the mission of central banks is in the current period.
Until a few years ago, central bank governors were looked upon as prophets of the global economy. Their statements made prominent headlines, and they always dealt with one main subject: the war on inflation. This was the system that defined them and in which they had been educated. Inflation targets, or money supply growth targets, were considered the pillars of monetary policy.
But then along came the financial crisis of 2008 and upended everything. Fiscal policy, especially in the EU, shed all responsibility for economic growth, and left monetary policy to cope alone with exiting from the slump. Thus was born the policy of zero interest rates and quantitative easing, which was meant to be a temporary stopgap. Yellen and Draghi dream of the day when they can revert to the "normality" they once knew, of raising interest rates.
Only the world has not been behaving exactly as expected by the central banks. The massive expansion of liquidity led to a rise in stock and bond prices, but did not bring in train a rise in inflation. On the contrary, if there is a problem that monetary policy is having to deal with, it is actually deflation. In these circumstances, a move to start reducing the inventory of bonds by central banks will lead to a rise in medium and long-term yields in the US and Europe, causing real harm to economic recovery.
If the central banks decide to forego, at least for the time being, a reduction in their financial assets, they will in effect abandon the fundamental assumptions on which they used to act, and in fact all the assumptions on which inflation target policy is based, including that of the Bank of Israel, will lose their relevance.
It may be that Yellen and Draghi will try to evade this question. In the end, however, there will be no option but to recognize the fact that the global economy is at a critical juncture, and that the central banks have no tools with which to deal with the problems that have arisen, in no small part because of a policy adapted to a different reality.
Flug's dilemma
Where are we in this story? Governor of the Bank of Israel Dr. Karnit Flug will also be at Jackson Hole. The Bank of Israel too faces a situation that is out of line with its basic assumptions. In case anyone has forgotten, the Bank of Israel bases it monetary policy on one main measure - the inflation target range of 1-3%. For many years, this target served the Bank of Israel well, and was an anchor of public expectations. But for some time now, in the process of the economy adapting to the post-financial crisis reality, this anchor has slipped. Local inflation has been below the target range since early 2014, and this year the Consumer Price Index will post a substantial drop.
When it becomes impossible to guide expectations by means of an inflation target, as has been the case for four years, the central bank can employ statements as a kind of guidance to the markets for what to expect in the future. In this way it is possible to influence yields and exchange rates. But the bank's ability to guide the financial markets, the foreign exchange market, and business, depends entirely on its credibility. If its credibility is eroded, then the bank's future pronouncements and guidance will be questioned.
The Bank of Israel's latest inflation report, which covered the second half of 2016, still expressed the view that inflation expectations are beginning to climb. In its policy setting, the bank tried to find evidence that it was possible to return to the inflation target range. In fact, in 2017, deflation has deepened, and the gap between what is happening in the economy and the official target has widened.
Flug, like Yellen and Draghi, cannot in the current reality hold onto the inflation target policy by force. A new policy is required to replace it, with tools to implement it. It is doubtful whether there is any central bank in the world, not just in Israel, that knows what such a policy should look like and what tools are available.
Flug can derive comfort from the fact that the Bank of Israel is not alone in facing a dilemma. Perhaps after the Jackson Hole gathering, the central bank governors, and Flug among them, will have at least a partial answer to the problem.
Published by Globes [online], Israel business news - www.globes-online.com - on August 23, 2017
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