Friday, August 24, 2017: the annual gathering of central bankers and policy makers in Jackson Hole has attracted extensive press coverage. Janet Yellen – the current Chair of the Federal Reserve – gave a speech. Not in Washington or New York, but in the quiet little town of Jackson, Wyoming. Janet Yellen was not the only one to give a speech. In fact, almost any important person in the world of central bankers joined this annual symposium organized by the Kansas Fed. Even ECB Chair Mario Draghi gave a talk (which was surprising, given Draghi’s absence from earlier editions of the symposium). The history behind the Jackson Hole symposium is interesting in itself, but the themes that were discussed might be even more interesting. Unfortunately, the formal speeches were boring, predictable and irrelevant. But there is no doubt in my mind that the real issues were subject to debate but in a more informal setting behind closed doors.
The Federal Reserve in Kansas has been organizing this meeting for the past thirty years. For the first time ever in 1978, various important economists, bankers and Fed presidents gathered to discuss important monetary issues, such as the spiraling inflation at the time (especially in the 70s!), the money supply, the banking system, monetary policy and the future of central banking.
Whatever the case, in the late 70s the (literally) towering Paul Volcker was Chair of the Federal Reserve. This democrat was later widely praised and even regarded a national hero. He was, after all, the one responsible for saving the dollar. After president Nixon decided to abandon the gold standard in 1971, and ended the convertibility of the dollar into gold, the US went through a difficult period. The famous era of stagflation was dawning. Something that was previously deemed impossible by virtually every economist happened anyway: economic stagnation (two recessions) and high inflation (double digits). The term “stagflation” was coined.
Paul Volcker had to watch in agony how the dollar was collapsing until he was appointed Fed Chair. Persuaded by the ideas and theories of Milton Friedman, face of the famous Chicago School, Volcker began to raise interest rates to curtail the growth in the US money supply, following Friedman’s lead. Milton Friedman was very influentially at that time in the US. He just published a book on the Great Depression in which he blames the Fed for the terrible crisis of the 1930s. The Fed, he argued, committed a great mistake by not taking countermeasures against the sudden drop in the money supply. According to Friedman, the consequences were inevitable: a deadly deflation with the inertia of the Fed as the main culprit.
Not only did Paul Volcker swear by Friedman’s ideas, his later successor (and perhaps better known to our readers) Ben Bernanke even made an extraordinary remark in a public speech, in which he personally addressed Friedman (symbolically, at least, since Friedman was no longer alive by that time) and promised Friedman to never commit the same mistake that, allegedly, caused the Great Depression of the 1930s. Bernanke would do whatever it takes to avoid monetary deflation (a decline in the money supply): exactly the opposite of what Paul Volcker did in the 70s to fight off high inflation.
Paul Volcker is, on a side note, still alive and kicking; over 90 years old, but he continues to be very much involved in public policy: he is trying to make state budgets (states often use slick accounting tricks) more transparent through his own foundation, the Volcker Alliance.
Now you might think: what does all this have to do with the Jackson Hole symposium?
Well, the following: in 1978, the first symposium was held, but in 1982 the Kansas Fed thought it was a good idea to invite the lead actor of everything that was being discussed to the party. But Washington and Kansas are not exactly the most enticing places to spend a mid-summer day: in August temperatures and humidity can rise to unbearable heights.
No way you could possibly convince Paul Volcker to come to either to attend a monetary conference.
But the organizers had thought about a workaround. Paul Volcker was a huge fan of fly fishing. What if they would organize the symposium in the best possible place for fly fishing? That is how they came to organize the symposium in a tiny place called Jackson Hole in the state of Wyoming. Paul Volcker was convinced and agreed to come, and that is how the first symposium in this tiny place near Jackson took place with the president of the Federal Reserve as one of the participants.
This tradition was continued over the years and that is why the same symposium still takes place in Jackson Hole. Traditionally, important central bankers gather here to discuss new developments in monetary policy. And this year, especially with the presence of Mario Draghi, two major issues will be subject to debate.
“What two issues?”, you might ask yourself by now. I will tell you which two:
- Draghi’s (sovereign) bond shortage
- Yellen’s excess (sovereign) bond supply
Both seem contradictory, but I have no doubt that by summarizing it in this way, I am not doing any injustice to reality.
Mario Draghi, and the European Central Bank (ECB), began an asset purchase program (better known as QE). The ECB buys – through their, what they technically call, large-scale asset purchase (LSAP) program – billions worth of government bonds and since recently corporate bonds.
But Mario is subject to self-imposed conditions and limits regarding his bond purchases. The ECB is not allowed to purchase more than 33% of the outstanding public debt of a country. (Because: that would mean direct government financing through the central bank which is not allowed. This is a somewhat strange way of reasoning, given the completely random and arbitrary limit of 33% of public debt. At what point can we conclude that ECB purchases are equal to direct government funding?)
And as it happens to be, that 33% self-imposed limit has just been reached for German and Portuguese sovereign bonds. In other words, the ECB board is in full-blown panic mode, because Draghi surely wants to continue its purchases of anything that moves and pays interest, especially now inflation is threatening to fall back to zero.
Draghi’s pressing question is therefore: what are we going to do? His options:
- Stretch the 33% self-imposed limit on bond purchases (to, for instance, 50%)
- Temporarily shift bond purchases to sovereign bonds of other countries than Germany and Portugal (which is politically almost impossible due to the, completely correct, idea that the ECB would “favor certain countries over others”)
- End or taper the asset purchase program in the short run (speculations on a possible tapering of the ECB’s bond purchases led to a rally in the euro recently)
- Shift asset purchases toward other assets than sovereign bonds (corporate bonds, for example, but the European market for corporate bonds is not even close to being large enough to satisfy the ECB’s thirst for interest-yielding assets
Janet Yellen has other troubles. She will taper gradually the Fed’s balance sheet, but of that will be easy and without any problem is an important point of debate. I, personally, am convinced that tapering will not be without pain. But there are economists (I spoke recently with one of the so-called Chicago Boys partially responsible for the Chilean economic miracle) who seem to think that tapering and reducing the Fed’s balance sheet is not a problem at all.
But the problems that the Fed faces should be clear to anyone: what if the mortgage-backed securities are no longer worth for whatever value they are parked on the Fed’s balance sheet? What if for every dollar invested in mortgage-backed securities (MBS) a mere sixty cents can be recovered? In that case, the Fed has an enormous problem: it will be unable to withdraw the provided liquidity from the market; it would be unable to pay off the bank reserves that were created after the Great Recession of 2008 began and all hell broke loose. That would make any reduction in the size of the Fed’s balance sheet difficult or unlikely. It may be that, for now, this is not yet relevant, but whenever inflation increases, it would mean an insurmountable problem for the Fed. And this inability to withdraw liquidity means even higher inflation as soon as inflation starts picking up even slightly.
This could only be prevented by waiting until your investments (in this case, sovereign bonds and MBS) mature and are being repaid (the Fed has recently decided to stop reinvesting part of the proceeds of maturing bonds into new bond purchases). An exit strategy seems, therefore, somewhat complicated. Since all the Fed’s assets are sovereign bonds with very long durations. Waiting until each and every one of them matures can easily take more than a decade: a complete illusion.
Who knows what the conclusions of our central bank overlords during the Jackson Hole symposium of 2017 were. We will see what both Draghi and Yellen will do with their respective balance sheet headaches.