Fed Focus

Longer & Mostly Milder, but Don’t Sneeze

Rising interest rates probably won’t help the startup series, outlined below, head northward. How does the current tightening cycle stack up against earlier instances?

Longer and mostly milder, in a phrase.

Over the last 35 months, since the tightening began in December 2015, the fed funds rate is up 196 bps. The average of the previous six cycles shown is 648 bps over 22 months, though the range in both magnitude and duration is wide.

But the current rise in rates is starting from a very low level (0.24%). The previous low starting point was 1.03% in 2004; the average, excluding the recent cycle, is 5.26%. If we look at the percentage (not percentage point) rise from the starting point, we get a very different picture. The bottom graph indexes the fed funds rate in the base month to 100. By that measure, the current cycle is the winner, with a current index value of 917. In second place is the 2004 cycle with a maximum value of 510. The average of all the previous cycles, again excluding the current one, is 277.

So, while the current round of tightening looks mild if you look at the level and change in nominal rates alone—a mildness accentuated by the slow pace of tightening—the change from record low interest rates to something more normal is nothing to sneeze at. A stumbling stock market is the least we can expect if this continues as it’s likely to.

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Trends in FOMC projections

We thought some graphs of the FOMC’s projections and revisions would be useful as Chair Powell takes the helm. In a phrase, they’re pretty good when things are on trend, but they’re pretty bad when they’re not.

Note that they had no inkling of the 2008 recession. In fact, as late as October 2008, they were projecting 0.2% GDP growth for the year, when it turned out to be -2.8% for the year ending in 2008Q4.

Their projection for unemployment was almost a point too low. And their projection for inflation, even late in the year, was way too high.

They didn’t really begin to regain their bearings until well into 2010—but the forecasts for 2012 remained on the bullish side until late that year. More recently, they underestimated growth for 2017—though their projections for 2018 have been creeping higher.

Through most of this history, they’ve overestimated inflation. But now they’re projecting that it’s going to hang just under 2%. You have to wonder if they’ve finally figured this out just as the world is about to change.

We say this not to make fun of the Fed. Economic forecasting is a very hard job. Most forecasts just extrapolate the recent past into the indefinite future. Sometimes that’s the right thing to do—but not always.

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What Jerome Powell thinks about ‘flation

Because he was more of a regulator than economist, Governor Powell flew below many radar screens. All that changed when he became a clear contender to be the new head of the Federal Reserve, and we’ve had a lot of homework to catch-up on, reading speeches he has given over the last year or so to become acquainted with his macroeconomic outlook. On the rate front, he told us what we need to know last June in his remarks, then ignored now widely quoted, to the Economic Club in New York City: “The Committee has been patient in raising rates, and that patience has paid dividends.”

Just as importantly, it appears he is among those questioning why inflation is so low, which would also encourage a patient approach to normalizing interest rates.
Let’s start with his understanding of interest rates. The following excerpts are from a speech given on January 7. 2017:

There are also many factors other than monetary policy that are holding down long-term interest rates. Long-term nominal and real rates have been declining for over 30 years. The next slide decomposes long-term nominal yields into expected future short-term real rates, expected future inflation, and a term premium. These estimates are based on one of the Board’s workhorse term structure models. All three components have contributed to the downward trend in long-term nominal yields….
The downward trend in nominal term premiums likely reflects both lower inflation risk and the fact that, with inflation expectations anchored, nominal bonds have become an increasingly good hedge against market risk. That has made bonds a more attractive investment and reduced the term premium.4 As shown in the next slide, a regression of the 10-year term premium on measures of 10-year inflation expectations and a rolling beta of Treasury returns with respect to equity returns (to proxy for the hedging value of bonds) shows that these two factors can account for a large part of the decline in the term premium.

The accompanying slide puts this remark into perspective:

There is a large amount of research explaining why global interest rates are so low. Bernanke’s global savings glut theory,an idea that is still relevant, was the famous first attempt. Others (Brainard) argue that lowered inflation expectations support the decline. As for inflation–another component of the interest rate equation–there are a number of theories about why it is so low. These range from increased international competition to technology creating more price transparency. Finally, research by the San Francisco Fed also explains low rates using standard, economically accepted methodology.

Regardless of the underlying reason, Powell clearly understands there are fundamental reasons for low interest rates. They are not low because of some vast conspiracy. By signaling his acceptance of the underlying research, we can conclude there will be no fundamental change in the underlying market philosophy espoused by the Fed.

What about the pace of increases? Those are likely to be slow:

The healthy state of our economy and favorable outlook suggest that the FOMC should continue the process of normalizing monetary policy. The Committee has been patient in raising rates, and that patience has paid dividends. While the recent performance of the labor market might warrant a faster pace of tightening, inflation has been below target for five years and has moved up only slowly toward 2 percent, which argues for continued patience, especially if that progress slows or stalls. If the economy performs about as expected, I would view it as appropriate to continue to gradually raise rates. I would also see it as appropriate to begin the process of reducing the size of the balance sheet later this year. Of course, both decisions will depend on the performance of the economy.

Powell has noticed the weak pace of inflation increases, which was again highlighted in this week’s PCE release:

He has made no more recent comment on the topic, so we don’t know if his thinking has changed. But recent Minutes indicate the Fed is starting to look more deeply into the low inflation situation and may start to rethink their overall philosophy in this area.

The bond market is stodgy, need we add? It would react poorly to a radical change in Federal Reserve philosophy. Powell seems to be a solid, middle-of-the road candidate. While he doesn’t have academic economic training, all evidence is he has worked diligently to learn. Overall, it appears Powell will provide “steady-as-she-goes” leadership.

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Fact Checking with James Bullard

Saint Louis Fed President James Bullard has been speaking out a lot recently. He recently proposed a new interest rate regime that, instead of focusing on models, uses a very intuitive decision tree to determine if raising rates is appropriate. He gave a speech at the end of last week that asked three questions: would the US see GDP growth greater than 2% in the coming year, would inflation hit the Fed’s 2% inflation target and would wages increase as unemployment decreases. His answer to all three was, “Probably not.” And in a break from tradition, he relies on incoming data rather than models to support his conclusions.

Bullard first observes that U.S. growth since the end of the great recession has converged to 2%. The following graph illustrates his point:

Since the third quarter of 2009, the average Y/Y growth rate has been 2.1% while the median growth rate has been 2%. There is little reason to project anything but moderate growth in the third quarter. Industrial production and real retail sales have both slowed. The three-month average payroll job growth is 185,000 per month -a solid rate but not one that warrants robust growth projections. Real income excluding transfer payments continues to increase but at a slower rate. The New York Fed’s Nowcast for third quarter GDP growth is 1.46% while the Atlanta Fed is calling for 2.8% growth The average of these two projections is 2.1%, which happens to be the approximate average of the blue chip forecasting consensus. The preceding information supports Bullard’s argument that there is a low probability of anything but more moderate growth.

Bullard moves on to inflation, arguing that it is doubtful that inflation, as measured by the personal consumption expenditure price index, will broach the Feds 2% target. The following data supports his conclusion:

The BEA breaks PCE price data into three components: services, and durable and non-durable goods. Durable prices (in red, 10% of the index) have been subtracting from price pressures for the last 10 years. And their negative impact is pretty high: these prices have been contracting around 2% for the last year. Non-durable prices (in green, 20% of the index) are weak; they subtracted from inflation for all of 2015 and most of 2016, only recently adding any upward pressure. Their latest reading was for a 1.3% year-over-year rate of growthhardly anything to be concerned about. That leaves services (in red, 70% of the index) to create all the upward pressure that the Fed needs for PCE inflation to hit 2%. Statistically, that’s very difficult to do.

Several Fed governors have advanced different theories to explain why inflation is so weak. Some have argued that global supply chains allow producers to purchase products from low-cost areas, keeping internal price pressures low. Others have argued that real-time access to price information allows consumers to buy at the lowest cost, which continually squeezes retailers’ margins. Another theory states that an aging populationsuch as that in Japan, the EU, and the United Statesspends less, leading to lower demand, which translates into less demand-pull price pressures. Also consider that commodity prices are weak across the board, keeping input price pressures at bay. The real answer probably encompasses pieces of all these theories along with others that haven’t been considered yet. But regardless of the cause, it’s difficult to see why people continue to assert that inflation will return to 2% in the intermediate term. The data simply do not support that conclusion.

Bullard final point is that the Phillips curve is exceedingly flat. He offers the following table culled from academic research:

Clearly the unemployment rate/inflation rate relationship has weakened a lot. Minnesota Fed President Neel Kashkari, who was again the lone dissenter on June’s rate increase, offers the most logical explanation of this disengagement. To get around retirement issues and the like, he considers prime-age workers, and notes that their participation rate and employment/population ratio indicate there is more slack in the labor market than before the crash, and therefore there is room for improvement

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2% target? Inflation Didn’t Get the Memo

The Fed has publicly stated it has a 2% inflation target, but inflation has been stubbornly uncooperative in reaching that level. The PCE price deflator moved above 2% earlier this year, but has since fallen back, bringing both the overall and core rates back to 1.4%.

pce

The latest Fed minutes show, yet again, that the Fed is concerned about weak price pressures. We’re harping on this subject both because it’s very important, and because it reveals a bit of a dust-up within the Fed. Apparently there has been an ongoing debate within the Fed over showing a united front or encouraging dissent. We, of course, go with dissent, so to us the current inflation debate is encouraging.

Hale Stewart put together the following round-up of recent FOMC speak on that debate.

At their latest meeting, explanations for ongoing low inflation offered by the fed includedoffered by the Fed included:

… a diminished responsiveness of prices to resource pressures, a lower natural rate of unemployment, the possibility that slack may be better measured by labor market indicators other than unemployment, lags in the reaction of nominal wage growth and inflation to labor market tightening, and restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. A couple of participants argued that the response of inflation to resource utilization could become stronger if output and employment appreciably overshot their full employment levels, although other participants pointed out that this hypothesized nonlinear response had little empirical support.

Fed Governors James Bullard and Lael Brainard have been the most vocal on the problem that inflation, in Bullard’s words, “doesn’t seem to be related to the variables that we think it should be related to.”

Last week Bullard posted comments on the St. Louis Federal Reserve’s blog focused exclusively on the Phillip’s Curve, which argues that as unemployment decreases, wages increased. This relationship was first observed in the 1950s and became part of central bank policy making soon thereafter. While the 1970s stagflation experience soured the Fed on this theory, it returned to prominence in the 1990s. As many, including the gang here, have argued, the relationship between employment growth and wages is weak at best. The table below shows that even a nearly impossible 2.5% unemployment rate would cause only a minimal increase in PCE inflation (36 basis points). This research indicates that a basic relationship assumed by the Fed is no longer supported by the data, if it ever truly was.
phillips-curve
With the Phillips’ Curve either very flat or broken, what should we consider as the causes of current very low inflation? Lael Brainard – one of the Fed’s brightest lights – offers several explanations starting with import prices:

One key factor that may have played a role in the past three years is the decline in import prices, reflecting the dollar’s surge, especially in 2015. By contrast, in the 2004‑07 period, non-oil import prices increased at roughly a 2 percent annual rate and had a more neutral effect on inflation. Nonetheless, while the decline in non-oil import prices likely accounts for some of the weakness in inflation over the past few years, these prices have begun rising again in the past year at a time when inflation remains relatively low.

The following graph illustrates her point:

import-pr

The trade-weighted dollar (in green, of course) decreased 25% between 2002-2008. At the same time, import prices rose at fairly sharp rates. The exact opposite happened during this expansion: the dollar increased a little over 30% causing import prices to contract from 2012 to the beginning of 2017.

She also argues that underlying inflation–as well as inflation expectations–has decreased, which is best illustrated by the breakeven inflation rate, which subtracts the yields of TIPS, Treasury Inflation Protected Securities, from the corresponding treasury.

be-inflation

The 5-year (in red) and 10-year (in purple) breakeven rate each fluctuated around 2.5% during the previous expansion. But each has decreased in fairly pronounced ways in the last 4 years. The 5-year has dropped about 100 basis points while the 10-year is down about 75 basis points. This graph indicates that people believe price pressures are declining, so they’re demanding less interest as compensation.

Brainard offers two reasons why inflation expectations are declining:

One simple explanation may be the experience of persistently low inflation: Households and firms have experienced a prolonged period of inflation below our objective, and that may be affecting their perception of underlying inflation. A related explanation may be the greater proximity of the federal funds rate to its effective lower bound due to a lower neutral rate of interest. By constraining the amount of policy space available to offset adverse developments using our more effective conventional tools, the low neutral rate could increase the likely frequency of periods of below-trend inflation. In short, frequent or extended periods of low inflation run the risk of pulling down private-sector inflation expectations. (Note: Bullard has argued that the recent trend is the best indicator of inflation’s direction.)

The first theory has been advanced to explain Japan’s low inflation expectations, but while there is a correlation between the two statistical events, we don’t know if there is causation. The second is related to recent research from the San Francisco Fed, which observed that the natural rate of interest is abnormally low and has been for the duration of this expansion. Low interest rates can’t exist if inflation is high because at some point, the markets will demand sufficient compensation to the natural devaluation of this money.

As we noted last week, the Fed moves at a glacial pace, so don’t expect a sea change in their collective inflation thinking. In fact, several other speeches this week indicate that some governors are continuing to argue low inflation is transitory. However, Bullard and Brainard have at least put the ball in play and offered substantive evidence supporting a rethinking of the Fed’s recent inflation targeting failures. And we believe they won’t drop that ball.

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