By David Blitzer
Next week will be a double dose of Fed speculation and debate. First, on Wednesday at 2 PM the Fed will release the minutes from the last FOMC meeting on July 29th-30th. Then on Thursday evening, Friday and Saturday the Kansas City Fed will hold its annual economic policy symposium in Jackson Hole Wyoming. The symposium usually attracts a who's-who of international monetary policy and central banking. While the topic for this year, "Re-Evaluating Labor Market Dynamics" has been announced, the agenda and the speakers won't be revealed until the evening of August 21st. However, Janet Yellen is certain to be someplace on the program; Stanley Fischer, Vice-chair of the Fed, might also speak along with some academics and foreign central bankers.
Labor market dynamics - will the unemployment rate keep falling, what is the right number for full employment and what will make wages rise enough to spark inflation anxiety - are one of three key Fed issues expected to dominate both next week and the rest of this year. The other two are when will interest rates rise and how will the Fed manage to control them. After all the symposium's economic theory and econometrics fade away two questions will remain: Will the improving labor market spark inflation? Will rising interest rates reverse recent labor gains? If we believe recent statements by Janet Yellen, she sees little worry about the first question for 2014 or 2015, but has some concern about the second question which is wrapped up with how the Fed will raise interest rates.
Even though labor markets are the focus of the Kansas City Fed meetings, both interest rates and operating procedures will be discussed - during the breaks if not in the formal sessions. Not everyone is as sanguine as the Fed chairwoman that unemployment can continue to fall and wages can rise without an immediate inflation penalty. There is a more hawkish segment to both the FOMC and the meetings that will argue for an earlier effort to raise interest rates. Despite this, there is little evidence that the Fed will move before sometime in 2015, probably in the second or third quarters. The truth is that no one knows - or can know - because it depends on how the economy unfolds going forward.
The last puzzle is what the Fed should do to raise interest rates. Back before the financial crisis and QE 1-2-3 the Fed could adjust interest rates by adding or draining bank reserves from the nation's banking system. That worked then because the bank reserves were near the margin where a small drain would push the Fed funds rate up and a modest addition would send it down. No longer. Following quantitative easing, the banking system is awash in reserves and there is no way the Fed can drain enough to make a difference. There are other approaches available: adjusting the interest rate the Fed pays to banks on excess reserves held at the Fed is one, auctioning reverse repurchase agreements is another. These will work, but with little experience the central bank could overshoot the target or miss completely. Like the Fed, the market has little experience with these new operating procedures. When the Fed does raise interest rates, will the market know how to respond or will it overreact and send rates either surging or collapsing. The answer to that question may be the topic for the 2015 Kansas City Fed conference.
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