Fed Policy: Do Two Wrongs Make A Right?

Deciding on monetary policy is not an easy task.  It requires an acute sense of economic wisdom in reading the signs that the economic data throws out, and also an actor's skill and sense of timing to ensure that the words are delivered in exactly the right form at the right time. The Fed has a monumental decision to take this week - whether to raise rates for the first time since July of 2006. That is over 9 years ago, and reflects how serious the last recession (or "great recession" as it's now called) was, not only in terms of it's initial depth, but also because of the way the recession was initiated (through the housing and financial sectors), through the consequent sluggish recovery.

But I think some in the media are under certain misconceptions about monetary policy.  Monetary policy is undoubtedly "abnormal" at the moment, with no real ability to lower rates if we go into another recession, and righting this "abnormality" is probably the strongest argument for lifting rates right now, as there doesn't appear to be any inflationary pressures on the horizon.  At least that is the official line I hear in the media, but more on this later.

Source: New York Times

The two strongest reasons I hear that the Fed shouldn't raise rates (see Larry Summers's FT blog outlining why he thinks the Fed should not raise rates now) are that US inflation rate (measured by CPI or PCE measures) is still under the Fed's 2% target, and that although the US labour market has recovered, the lower participation rate and stagnant wages still point to persistent weakness.  Add to this the new "emerging markets" Quantitative tightening argument made yesterday quite forcibly by Gavyn Davies in the FT (see here)

But when I read both Larry Summers's and Gavyn Davies's arguments, they seem rather weak to me, and for the following reasons:

i) "Normalization" is important.  As a central bank, the main instrument that the Fed has is interest rates. Using QE was an experiment, an experiment that other central banks are now using, but where there is considerable and continuing discussion regarding the effectiveness of this relatively new policy.  As we are now nearing the end of the current business cycle ( - business cycles typically have length of 4 to 10 years), the Fed needs to put some real teeth back into it's monetary policy instruments so that it has the ability to effectively ease if and when another sizable downturn occurs.

ii) Inflation.  Inflation is currently low basically because of the role of lower oil prices in bringing down input prices throughout most of the economy.  But once crude oil prices begin to rise again, which they inevitably will, the distortion of such a large fall in oil prices will work in the opposite direction - it will tend to bias inflation upwards rather than downwards.  Now although we do not know the full effect of lower oil prices on inflation, the Fed is using the measure of prices minus food and energy, which only takes out the direct effect of volatile energy prices, and not the further effect of energy prices as an input into the production of other goods and services.  So my point here is that inflation, even measured without food and energy prices, is still downwardly biased. A better indicator is probably wages, and they are increasing now at a 2.5% year over year rate (average weekly earnings on private nonfarm payrolls).  That implies that indeed we now are looking at some inflation in the system with the likelihood that even if current inflation levels are subdued, the actual future inflation rate is likely to incorporate these cost increases, and so inflation should be on an upward medium term trajectory.

Source: http://blogs.ft.com/gavyndavies/2015/09/13/will-emerging-economies-cause-global-quantitative-tightening/

iii) External factors.  The Fed does not set monetary policy on the basis of economic conditions external to the US.  Nevertheless, that has not stopped institutions like the IMF, the central bank of India, and other central banks from weighing in to urge the Fed not to raise rates in September.  Indeed, the sales of dollar reserves in the form of US government bonds has led to a tightening of interest rates which, as Gavyn Davies has pointed out in the FT, is an implicit tightening of policy in the medium term bond yields (around 10 years).  The figure on the right shows this trend, and indeed from a global perspective this trend is sufficiently large as to potentially swamp injections of liguidity through QE from both the ECB and the Bank of Japan. But I would argue that this is not relevant to the US - the US has to set monetary policy according to the economic and financial conditions in the US, and not elsewhere.  If the Fed starts to take these kinds of factors into account, then the Fed will no longer be setting US monetary policy - instead it will be setting global monetary policy, and this is not in it's mandate.

So to end this blog posting I want to make the case that 2 "wrongs" don't make a "right".  The Fed was wrong not to go in 2014 when it clearly had the chance to start the "normalization" process earlier in the growth phase of the business cycle.  For the reasons I have outlined above it would also be wrong not to increase rates now at the September meeting as well.  And yet there are still some commentators who suggest that it would be right not to raise rates this week.  My own assessment of the situation would be that the Fed would be falling seriously "behind the curve" on normalization of monetary policy, which could have extremely negative effects in 2016 or 2017 if and when the next recession arrives. Now the response to the points outlined here would undoubtedly be "but we could always do a QE4" - but no central bank really wants to extend the exceptional circumstances further unless absolutely necessary, and it would be a massive mistake if the Fed were to assume that the US economy could be effectively protected solely by a QE4. That would be like waging a battle with only air cover, and no infantry!

The Unlikely Miracle of an Immaculate Monetary Exit

Recently, The Economist magazine reported (see here) that Richard Barwell of the Royal Bank of Scotland had made the comment that, for central banks to withdraw from the massive monetary stimulus they have delivered to the economy without any problems, then the stimulus should be withdrawn before the economy really is back on track again, and also for "central banks' economic forecasts to be unerringly accurate".  But in my view there is much more to this than just the timing of the withdrawal of the stimulus, particularly in the US, or the accuracy of central bank forecasts.

If one looks at the 10 and 30 year US government bond yields going back to the beginning of 2008, so just before the "great recession" started, from the chart below you can see that 10 year bonds were at 4% and 30 year bonds were at 5%.  What is astonishing about this chart is the big fall in US long bond yields that occurred in the late summer of 2011, and you might immediately assume that this marked the beginning of one of the "QE" programs of quantitative easing mounted by the Fed.  But you'd be entirely wrong here - it was essentially the beginning of "operation twist", where the Fed committed to buying more longer term Treasuries, or moving further down the maturity spectrum by buying more longer term bonds and selling shorter term ones.

We have never returned to those post-recession higher levels for 30 year bond yields ( - the 4-5% range), nor the 10 year bond ( - 3-4% range), despite having inflation that is roughly the same, if not higher than during that period.  Even during the "taper tantrums" of 2013, 30 year rates never quite got to 4%, and 10 year bond yields only briefly touched 3%.  Not only that, but the gap between the yield rates has been shrinking so that since early 2013 it is a full 0.5% smaller.

Let's have a look at real bond yields for the same maturity bonds (courtesy of the US Treasury's bond pages here). What's clear is that the "operation twist" announcement sent US 10 year real bond yields into negative territory for all of 2012 and the first half of 2013.  It's also noticeable that US real long bond yields are now not negative ( - but of course short term bond rates are). But it is also clear that it would be pretty exceptional circumstances that would send the US 10 year real bond yield into negative territory. In other words, to quote the pop band Yazz - "the only way is up"!

That also makes sense when considering both inflation and real GDP.  Current inflation is 2.1% on a year over year basis in June,   and current real economic growth on a year over year basis in Q2 is at 2.43%, not at all bad, considering the set back to output that the economy had in Q1 due to all the bad weather. Heck, some components in the CPI are just skyrocketing - such as Meat, Poultry, Fish and Eggs (up 7.5% yoy).  These are all products that we eat, and no doubt they will feed into higher grocery bills pretty quickly.  These levels of macroeconomic performance hardly warrant long interest rates in nominal terms at 2.5% or in real terms at 0.25%.

 

In other words, I would expect to be seeing both short and long interest rates at much higher levels than they are right now, but particularly longer rates, given that the economy is likely to be going through more rapid growth going forward than it has in the recent past.  All these predictions about continuing sluggishness in the economy have been underpinned by the Fed's continuing commitment to low interest rates ( - Yellen's claim that the FOMC is in "no hurry" to raise rates), and their "gradualist" ( - some might say irresponsible) and non-differentiated taper. 

 

And that is the danger.  The "gradualist" approach might be just a tad too gradual - and stimulative.  As central bankers are fond of saying, the Fed's job is to pull away the punch bowl just as the party gets going. But in my view the trouble is that the Fed is still spiking the drinks, when already some of the party guests appear to be a little tipsy. 

 

One of the biggest dangers that Fed Chairperson Janet Yellen faces is that she doesn't act quickly enough. After previous recessions, the Fed was often too late in tightening policy and the result was having to rapidly adjust interest rates upwards extremely quickly. Unfortunately the slowdown in Q1 might have laid a trap for the new Fed Chairperson, in that it was a brief blip that has perhaps served to obscure what is really happening with the real economy.

 

All I can say is that I hope I am wrong here, and that the Fed is on course, but I think as each week passes the likelihood is that it is falling rapidly behind the curve on this recovery, and probably more worrisome, as the long bond yields show, that the bond markets have bought the Fed's arguments, lock, stock and barrel.