Analysis: What else happened at Jackson Hole? – r*, normalisation and participation
At the Fed’s annual Jackson Hole conference, markets understandably reacted to US Fed Chair Powell’s speech which effectively significantly divorced tapering from rate hikes. However, also discussed at Jackson Hole were several research papers that may shed light onto central bank thought over the next couple of years. Of particular importance were discussions around, labour force participation, the neutral interest rate, and finally how central banks should normalise policy. The key takeaway from these theoretical discussions were:
(1) The unemployment and participation cycles move closely together. Thus, declines in unemployment will naturally result in upward pressure on participation for all groups. Interestingly the cyclical lift in participation is not due to the entry of marginalised workers, but rather from employed people staying employed and the unemployed becoming employed (rather than leaving the labour force). Using detailed flows data, the paper concludes around 90% of the recent drop in the participation rate is cyclical. Jackson Hole paper: Maximum Employment and the Participation Cycle.
(2) r* (the neutral rate) decline can be better explained by rising income inequality than by the ageing of the baby boomer generation. This is because saving rates are significantly higher for high income households within a given birth cohort relative to other households in the same birth cohort. There has also been a large rise in the income share for higher income households since the 1980s. If the inequality driven view of declining r* is correct, it suggests we should focus on inequality as an important factor when judging where rates will be. The lack of political appetite to increase taxes on high income earners and capital to re-distribute wealth also suggests such a trend is likely to persist. Jackson Hole paper: What explains the decline in r*? Rising income inequality versus demographic shifts.
(3) For policy normalisation several factors need to be considered. Should rate hikes occur before central banks contemplate unwinding QE purchases for example? Given the limited experience unwinding QE, it is more likely central banks will gradually lift rates first. Some weight towards unwinding QE purchases early should be given as it would re-assert central bank independence from fiscal authorities and remove stimulus from the US housing market. Given the uncertainties involved, central banks will need to give clear communication before adjusting balance sheets. Jackson Hole: Unwinding Monetary Stimulus in an Uneven Economy: Time for a New Playbook?
Overall, the papers suggest there are legitimate grounds for thinking the downward trend in r* may be sustained which has implications for how high interest rates may go in the next upcycle. Central banks are likely to lift rates before thinking about unwinding QE purchases, while the Fed is likely to continue to work on what ‘maximum employment’ is with unemployment still a useful summary indicator of conditions.
Chart 1: is rising inequality the reason r* has fallen? (note data is for the US)
Chart 2: top 10% have been capturing more of the income share over the past few decades (note data is for the US)