Don Kohn’s reflections on Jackson Hole 2024

Don Kohn holds the Robert V. Roosa Chair in International Economics and is a senior fellow in the Hutchins Center on Fiscal & Monetary Policy in the Economic Studies program at the Brookings Institution. Kohn is a 40-year veteran of the Federal Reserve system, serving first as a staff economist, and from 2002 to 2010 he was a member and then vice chair of the Board of Governors. Since the 1980s, he has been a frequent participant in the Kansas City Fed’s high-profile Jackson Hole conference. David Wessel, director of the Hutchins Center, talked to him about this year’s conference.

David Wessel: In his Jackson Hole remarks, Fed Chair Jerome Powell said—pretty explicitly for a Fed chair—that the Fed is poised to cut interest rates at its September meeting, and that it doesn’t “seek or welcome further cooling in labor market conditions.” Did that reflect the consensus of the participants in Jackson Hole this year? What was the mood at the conference this year?

Don Kohn: The mood in Jackson Hole was more relaxed than the last couple of years. Inflation is coming down everywhere in the developed world (except for Japan, where they want it to go up), and people were pretty optimistic about continued declines in inflation. Mentions of “last mile” challenges to achieving a 2% target were much less frequent than at last year’s conference, but they weren’t entirely absent; inflation remains above 2% most places, and some had questions about how assured meeting the target might be, especially outside the U.S. 

In that regard, Powell’s speech was more forceful and forward leaning on the easing side than many expected, myself included. It was a complete pivot from ‘whatever it takes’ on inflation to ‘whatever it takes’ on the labor market, and seemingly no worry that they might not make that last mile to 2% inflation. It was all about easing policy to support the labor market. And there were no cautionary words about the pace of easing—other than it would depend on incoming data.  Notably absent were references to ‘gradual’ and ‘measured’ rate cuts, the kind of words that his colleagues of the FOMC have been using. The speech could be read as supporting a 50 basis point cut in September—although he didn’t say that explicitly—and more cuts after that. Moreover, he didn’t address the extent of the easing that he anticipates. There was no discussion of r* (the long-run equilibrium interest rate.) It was all about the direction of travel, with a focus on the labor market. I had the sense that FOMC members generally favor a 25 basis point cut in September, but some would have been more cautious than Powell was on speed and extent, and these members have more residual concerns about inflation than he expressed. Financial markets picked up on Powell’s message; they anticipate significant easing this year. 

Wessel: Did you hear anything interesting about the monetary policy debate in the U.K. and Europe?

Kohn: The Europe and U.K. discussions were interesting. In Europe inflation is definitely coming down—but, for core, more slowly than ours. There is concern that service inflation is high associated with outsized wage increases. As one European put it to me: Your wage increases are becoming more consistent with your inflation target than ours. And elevated wage increases persist even though the European economy is weak, largely reflecting weakness in Germany. They view their r* as lower than many people view ours—maybe around zero. So Europe is in a less favorable situation than we are. As a consequence, they are more cautious about the pace of easing. ECB President Christine Lagarde was not there, but she has cautioned against counting on a rate cut every meeting.

With respect to the UK, Bank of England Governor Andrew Bailey gave the lunch speech. The BoE cut rates at the last meeting but by a 5-4 vote. Judging from Andrew’s speech, the BoE’s story is that inflation rose because of an adverse shock to terms of trade—the weakness in the pound plus the rise in energy prices. The question is how this is feeding through to the labor and product markets. Bailey was explicit that they are wrestling with the extent and persistence of second-round effects of what he called the “extensive” external shock. That would be determined by “intrinsic” persistence resulting from decision-making in labor and product markets in response to the shock. The concern is that inflation is not coming down that fast, which could affect inflation expectations. He and everyone else emphasized the importance of keeping those expectations anchored around central bank targets. Although direction of travel is the same as in the U.S., my impression was that in both Europe and the U.K., the dynamics of wage-setting are creating more uncertainty about how far and how fast the central banks can cut rates.

Wessel: The U.S. economy doesn’t seem to have responded as it has in the past to the Fed’s sharp increases in interest rates. Given that the title of the conference was “Reassessing the Effectiveness and Transmission of Monetary Policy,” was there any interesting discussion of changes in the monetary policy transmission mechanism?

Kohn: There wasn’t an overall summary of that, but there were interesting snippets.

The muted response of the economy to tighter policy may not be related to the transmission of monetary policy itself, but rather to what else has been going on. High on that list would be expansionary fiscal policy. And the huge fiscal stimulus of 2020-21 has had a long tail in the form of spending from all that excess savings from the pandemic-related aid. Another thing working the other way have been financial conditions. For a long time, driven, importantly, by optimism about AI, the stock market has been rising. And house prices also have been going up rapidly. Increasing wealth has helped support the economy.

So tighter monetary policy was offset in part by other things. By the way, it looks like monetary policy was as effective as it needed to be: It damped demand enough to reduce job vacancies, wage growth, and inflation. Whether inflation gets durably to 2% is still unclear, but there’s optimism because a lot of the remaining inflation has to do with housing, where rent increases have been slowing.

Wessel: I understand there was some discussion about the mortgage market.

Kohn: Yes. One focus was the impact of the Fed purchasing and then running off mortgage-backed securities. One of the papers, presented by Philipp Schnabl of NYU, said that the effect of the Fed’s purchases of mortgage-backed securities and Treasuries went beyond simply lowering the general level of long-term interest rates. He estimated that purchases of MBS reduced the spread of mortgages over Treasuries by 40 basis points, indicating that such purchases are a powerful weapon the Fed now has. But Kristin Forbes of MIT, the discussant, disputed that 40 basis point estimate. She cited other studies that suggested a smaller effect.  More broadly, Forbes also recalled that she had previously wondered why the Fed was buying MBS at all in 2021 when real estate markets are on fire, a question that I’ve also had.

Another topic was the cash flow channel of monetary policy. Think about countries where all the mortgages have floating rates or rates that are only fixed mainly for a short time—3 or 5 years. When interest rates go up, the homeowners get squeezed because their payments go up, and that puts a dent in their consumption. The head of the Norges Bank, Ida Wolden Bache, devoted her 20-minute panel discussion to this. She showed that historically this cash flow effect had squeezed consumption and been an important channel for monetary policy effectiveness. This time however, consumption in Norway had not slowed much among highly indebted households, though she also questioned whether she was using a good proxy for the degree of indebtedness.  In the U.S., of course, 30-year fixed-rate mortgages are popular, and many people had locked in 30-year mortgages at very low rates so the rise in interest rates had no effect on the cash flow they had available for spending.

There was a lot of discussion about the cash flow channel and whether it is changing in Europe, where more mortgage rates are being fixed for 3 or 5 years. But I wonder about the macroeconomic importance of this channel. Cash flow is a zero-sum game. Your cash flow out is someone else’s income. Lower cash flow effects of rising rates help borrowers, but they hurt lenders and the savers funding them. It’s not like higher interest rates, which raise the cost of capital, leading people to reduce or postpone spending, and which can lower asset prices and wealth. 

Wessel: What else struck you as interesting?

Kohn: The effect of monetary policy on the labor market and the economy—particularly the non-linear Phillips curve (which describes the relationship between unemployment and inflation.) When the Fed put together their 2020 framework, they talked about a flat Phillips curve. If you push the unemployment rate down, you don’t get much inflation, so very little penalty for running a “hot” labor market. Gauti Eggertsson of Brown argued that at some point the labor market gets so hot inflation rises rapidly—there is a bend point in the Phillips curve where it goes north pretty quickly. At that point, you get much higher inflation if there’s a demand or supply shock because you’re on the vertical part of the Phillips curve. He advocated using the ratio of vacancies to unemployment from the Beveridge curve to gauge where we are on the Phillips curve. That ratio pointed to a much tighter labor market in 2021 than did the unemployment rate (in effect, the bend point had shifted to a higher unemployment rate) and helps to explain a portion of the rise in inflation. The nonlinear Phillips curve also helps to explain why the recent very modest increase in unemployment –but a large decline in vacancies—brought inflation down so quickly.

Fiscal policy and its interaction with monetary policy was also a major focus. A paper  presented by Hanno Lustig of Stanford used bond market responses to announcements of spending increases to hypothesize that the huge spending shocks in 2020 and 2021 converted the system from one of monetary dominance, where price stability would prevail, to one of fiscal dominance, where markets expected that inflation would ultimately need to be used to reduce the real value of government debt. Markets, he said, were beginning to wonder if there would be an ever-expanding supply of Treasury securities relative to GDP, where taxpayers were unwilling to bear the burden of higher taxes to stabilize or ultimately repay the debt. But discussant Anna Cieslak of Duke said it wasn’t a change in regime; other things could explain the rise in bond yields. In my mind, the fact that you run expansionary fiscal policy and interest rates rise may be nothing more than the crowding out described in my intermediate macro textbook. I agree with Anna and disagree with the implication that the U.S. has entered an era of fiscal dominance and that inflation will have to rise to deflate debt. To me, the growing federal debt is just producing a rise in r*.

Wessel: How about Fed communications? Anything interesting there?

Kohn: Communications are an important element of the transmission of monetary policy to markets and the economy. Everyone agrees that the better markets understand what the Fed is doing, the more they’ll anticipate what the Fed is going to do, and this will shorten the lags—the time it takes for monetary policy to have the intended effects on the economy. Eric Swanson of the University of California, Irvine presented some charts that showed that monetary actions have produced fewer surprises over time. He attributed the trend to better communication by the Federal Reserve, though he also noted some stumbles, suggesting room for improvement.

Another paper, presented by Carolin Pflueger of the University of Chicago’s Harris School, focused on economists’ perceptions of the Fed’s likely reaction to inflation. The authors used professional forecasters’ forecasts of interest rates and inflation to infer what they thought the Fed’s reaction to an inflation surprise would be. From 2021 and 2022, the response was practically nothing. It wasn’t until late 2022 on one measure and early 2023 on the another that this implied coefficient jumped. The implication was that the Fed wasn’t clear about how it would react to inflation. This is all complicated, though, by the fact that until late 2021, the Fed thought inflation was going to come down without much, if any, policy tightening. One recommendation from that paper is that the Fed should link each FOMC participant’s projections of interest rates to his or her projections of unemployment, GDP, and inflation. Even anonymized, that would give a better sense of how FOMC members view appropriate reaction functions.

On emerging markets, there was discussion of the globally synchronized increase and decrease in interest rates. There’s an open question about what that does to policy transmission. On the one hand, if interest rates are going up everywhere, that reinforces the cost of capital channel of monetary policies. On the other, if interest rates are going up everywhere, it cuts off the exchange rate channel. There were no conclusions about whether this synchronization made policy more or less effective.