Lessons in monetary transmission

With the much-anticipated Federal Reserve pivot upcoming, reports about this year’s Jackson Hole conference have mostly focused on indications about the trajectory of interest rates in the next few months.

While central bankers broadly agreed that easing is on the cards in the near term, there was less consensus about the issue that gave the conference its theme: monetary transmission and its effectiveness.

Policymakers appear to have reached different conclusions about whether the monetary tools available to them have worked as intended over the past few years. What’s more, they also seem to have different ideas about whether monetary transmission will work in predictable ways when the next crisis hits.

Let’s look at the conclusions of each central banker — and what they can learn from each other:

Powell: business as usual

For all its cautiousness, Fed chair Jay Powell’s keynote address projected an overarching sense of confidence in a job well done.

His diagnosis of the US economy’s issues over the past few years was clear and confident. In his telling, these challenges are now “fading”.

“Most of the rise in inflation [was due to] an extraordinary collision between overheated and temporarily distorted demand and constrained supply,” he said. In this set of circumstances, the Fed’s job was to “moderate aggregate demand, and [to anchor inflation] expectations”. He believes it succeeded on both counts.

His speech offered two messages.

First, monetary transmission worked exactly as intended via financial conditions and expectations. As Powell put it, “our restrictive monetary policy helped restore balance between aggregate supply and demand, easing inflationary pressures and ensuring that inflation expectations remained well anchored”.

Second, demand and supply shocks that caused inflation to rise above target did not bring structural change to the US economy. The implication is that monetary tools that worked this time can reasonably be expected to work in more or less exactly the same way when the next crisis hits.

What Powell did not mention is that in 2020 the Fed upgraded its policy framework to a new formulation — flexible average inflation targeting — with the aim to “offset the downward bias to inflation expectations exerted by the lower bound under inflation targeting”, as New York Fed president John Williams put it. Under FAIT, future inflation is allowed to overshoot the 2 per cent target when present inflation undershoots.

As Powell notes, inflation expectations have been well behaved in the US since then, falling sharply from elevated levels in 2022. But if Fed rates do not go back to the lower bound, it could mean that this time, the Fed has had more room to allow expectations to drift up than it will in the future.

Bailey: in the dark

Bank of England governor Andrew Bailey struck a far less confident tone.

First, he indicated that the BoE had not been entirely successful at managing inflation expectations. “Intrinsic inflation persistence where price and wage setting behaviour does change [ . . . ] is still with us,” he said, though he added that it had come down slightly over the past year.

Second, Bailey did not seem to have a clear sense of exactly what level of policy restriction would be needed to squeeze out the remaining persistence — or, indeed, which of the various monetary transmission channels would best achieve this goal.

“Is the decline of persistence now almost baked in [ . . . ] or will it also require a negative output gap to open up, or are we experiencing a more permanent change to price, wage and margin setting which would require monetary policy to remain tighter for longer?” he asked the audience.

Bailey’s uncertainty went further still. Elsewhere in his speech, he reflected that monetary transmission may not have worked as policymakers expected this time — both because of the significant structural changes to the economy since the last tightening cycle, and because of the peculiarities of raising rates from near zero.

If the transition from ultra-easy to tight policy altered transmission, the point is relevant not just for the BoE. In any case, he is right to point out that the global economy has changed a lot since the last global tightening cycle.

Lane: helped by circumstances

Like Powell, the European Central Bank’s chief economist Philip Lane sounded confident that the ECB’s policy stance had been transmitted as intended, though he noted that, as in the UK, “the return to target is not yet secure”.

But his description of the various channels of monetary transmission reveals that it was facilitated by a few external factors. At least some of these should not be expected to recur next time the ECB needs to raise rates, meaning that in a future crisis the ECB’s playbook might also have to change.

In terms of the impact of restrictive policy on aggregate demand, Lane said that weaker consumer confidence and skyrocketing energy prices after Russia’s invasion of Ukraine “reduced the extent of demand dampening that needed to be generated by monetary tightening”. This implies that if the next bout of high inflation is caused by a shock that works against tight policy, such as a positive demand shock, monetary transmission will be less forceful. Lessons from the past tightening cycle will not necessarily apply.

The ECB’s tightening campaign also prevented inflation expectations from becoming unanchored, Lane said, but he also noted that “in the post-crisis years before the pandemic, expectations had become de-anchored to the downside”.