Central bankers from around the world are gathering in Jackson Hole, Wyo., for an annual symposium organized by the Federal Reserve. Investors are watching the symposium closely, paying especial attention to Fed chairman Janet Yellen and European Central Bank president Mario Draghi. Yellen and Draghi both deliver speeches tomorrow, and those speeches could give clues about the direction of future monetary policy. Before that happens, it’s worth considering the importance of monetary policy to the present economic situation.
The Fed’s mandate from Congress is to “promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.” One lever it has to fulfill that mandate is to manage the money supply by raising or lowering short-term interest rates. Recently, Yellen’s policy has been to tighten, but gradually: The last target rate hike came in June to the tune of 0.25 percentage points, pushing the target rate up from 1 percent to 1.25 percent. Yellen is raising rates because, with the U.S. in the eighth year of an expansion, she expects inflationary pressures to emerge. Announcing the rate hike two months ago, the Fed stated its expectation that “economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further.” The basic idea is that as the cost of labor rises, prices will rise in turn. So the Fed, in keeping with its mandate, has been tapping on the brakes. (Some have argued that it doesn’t need to quite yet, and it is an interesting question to think about.)
Where we are in the business cycle has a lot to do with monetary policy, and monetary policy has a lot to do with where we’re going in the business cycle. Yellen and Draghi, then, walk a thin tightrope. Years of credit growth in the U.S. and Europe have left households and businesses saddled with debt, one reason the financial crisis in 2008 was more severe than most downturns. If the central bank tightens too quickly or to too great a degree with a highly leveraged economy, it could crush spending and drive the economy into recession: Are you really going to buy that car now that rates are five percent and debt collectors were already on your case? And are you really going to hire people to build cars if nobody is buying them? That’s part of the reason that Yellen has been so cautious to raise rates.
The short of it is that central bankers are important because their decisions affect the economy and where people expect it to go. They know they are, too, and hedge their words to an almost-political degree. On June 27, for instance, Draghi assured listeners that the ECB would “adjust the parameters of its policy instruments — not in order to tighten the policy stance, but to keep it broadly unchanged.” But despite such cautious language, markets moved as though Draghi had transmogrified into a peregrine falcon, with stock futures falling and bonds selling off.
Such market movements have consequences for anyone with a retirement account. There are also political implications: politicians rely on financial markets for positive PR, and promise jobs even when central bankers might want to cool the economy down.
So Friday’s speeches by Yellen and Draghi matter — and not just to those who trade on this stuff.