Janet L. Yellen, chair of the Federal Reserve (Bloomberg News)

I will not be attending Jackson Hole this year but I will be thinking about some of the issues under discussion. As I have written recently, I think the period going forward will be more challenging for central banks than the preceding few years. I will sleep best at night if Janet Yellen is reappointed.

Even though the Fed has raised rates more than I would have preferred and done far more signaling of future rate hikes than has seemed reasonable to me or for that matter to markets, it could have been much worse. I do not see a case for a further rate increase on current facts and remain very concerned that macroeconomic policy has inadequately internalized all the aspects of large declines in the neutral real rate and secular stagnation risks.

I have recently rehashed the issues bearing on inflation and monetary policy. In brief, the salient points are: (I) inflation is below target and expected to remain well sub-target for the next five, 10, 20 and 30 years; (II) it has been well below target and Fed forecasts for a decade, suggesting great skepticism about models that predict acceleration (III) the 2 percent target is supposed to be an average so inflation should sometimes exceed it especially after a long shortfall; (IV) if the ninth year of expansion with unemployment approaching 4 percent is not the time for above-target inflation, when will that moment ever come? (V) it is better to make correctable errors and as we have learned painfully over the last decade inflation is more easily addressed than deflation.

Against this are posed two main lines of argument.  The “sudden stop” theory holds that if inflation accelerates too much, the Fed will have to raise rates fast to stop it and send the economy into recession.  The evidence cited by Boston Fed President Eric Rosengren is that whenever unemployment rises by more than a few tenths of a percent, it rises a lot as the economy goes into recession.  What does this prove? When the Fed has raised rates to stop inflation as in 1982, it has wanted to slow the economy way down. The failure to achieve a gentle slowdown when it was not the objective proves little.

These arguments are unsettled but pretty well discussed. Progress will likely require a greater understanding of the breakdown in the Phillips curve than we now have. I suspect, especially given the press previews of Yellen’s speech, that issues around monetary policy and asset prices will loom large in Jackson Hole.

The “financial conditions” argument regarding monetary policy has been made most strongly by New York Fed President Bill Dudley. It holds that recent monetary policy tightening has not tightened overall financial conditions as reflected in credit and term premiums, stock prices, and foreign exchange values. The implication is that further tightening is necessary to regulate demand and also to avoid bubbles.

The fatal flaw here is failure to recognize the importance of fluctuations in the neutral rate and market perceptions of its future level. Suppose as has been true in recent years that the neutral rate falls. That reflects an decrease in investment demand relative to saving supply and so is a reason other things equal for easier money. What will happen to some financial conditions index? Stock prices will rise because of a lower discount factor. The dollar will fall because of lower rates. Long rates will fall because of reduced real rate expectations. Financial condition indexes will show great ease even when developments call for more easing.

Similarly judgments about bubbles need to be reached in the context of the level of neutral rates. Levels of price-earning ratios that would have looked bubbly with a 2 percent neutral real rate are much less so with a zero neutral real rate.  Moreover, judgments about bubbles need to be made in context of fundamentals. The Fed seems more alarmed this year than last about valuations, but the reality is that the ratio on the S&P 500 relative to either trailing or forward earnings has remained stable. Surely the weakness of the dollar is a reflection in significant part of strengthening fundamentals in Europe, which if it signifies greater competitiveness is a reason to ease not tighten.

There is a further point as well. Monetary policy works with long lags. If policymakers were confident that asset markets were at bubble level what is the right response? Should they prick the bubble? Or suspecting that is about to burst should they, in Tim Geithner’s famous phrase, “lay foam on the runway” by keeping policy easy? The case for financial stability tightening rests on an ability to see bubbles well in advance. That is asking a lot.