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 US economy in 2015: Punch drunk, great DJ, but where is the Exit?

Fed Chairman William McChesney Martin once said  ( - apparently in a speech in 1955, and I paraphrase here), that that whole point of monetary policy should be to remove the punch bowl just as the party gets started". In the spirit of Christmas panto, and to continue the analogy, the drinks are now pretty strong (maybe shots?), and what's more, a talented DJ has just arrived and (s)he seems to really be dropping some great tunes and the party is beginning to look like it will roar!

The really interesting part to this story though, is what happens next? Does the host suddenly decide to hide the punch bowl and threaten to call the police to really put the dampers on things; or does the DJ run out of interesting tunes to drop because (s)he only brought a limited number of tunes; or is the DJ so good that it gets the neighbors involved to really spread the joy and make the whole party rock, with the distinct possibility that the police will show up in force, but only much later?

Those of you who know some economics will recognize the characters here: the DJ is the price of oil, the police represent inflation and the host is the central bank, with the punch bowl being accommodative monetary policy.  We all know that all 3 ingredients make the best parties - good drinks, often supplied by the host, no likelihood of police presence (perhaps because the neighbors are compliant and/or fun loving people) and a good selection of music to really get people in the right mood.

Now the economics.  OK, the precipitous fall in oil prices is good for most countries, and is even moderately good for the US, although it will definitely deliver some pain in some regions (like my own - South Texas).  But after watching an interview by the illustrious Simon Hobbs on CNBC, where he talked about signals that we are approaching the “end of the cycle” I got to thinking about whether Simon was correct, and whether the current oil price decline might soon sow the seeds of the end of the growth phase of the current business cycle.

So let’s look at some stylized facts:

i)   Business cycles typically last between 4 and 10 years;

ii) When the previous recession had, as it’s proximate cause the banking sector, research (by Reinhart and Rogoff) shows that the recovery is anemic;

iii) Central banks are pretty much exclusively focused on inflation and inflation targeting plus slack in the labor market these days; and

iv) Oil price rises tend to slow economies down.
So let’s see where we are on each of these stylized facts. 

First, given that these 4-10 year periodicities are roughly right, and I see no reason to believe that they are not, then as we recently passed the 5 year mark of the emergence from recession, we are definitely in the mid-stage if not heading into the late stage of the business cycle.

Second, the recovery from the previous downturn has been anemic, as anticipated, but this is partly due to the very tight restrictions on bank lending – these are now being relaxed, plus although the housing sector has not been wonderful of late, there are now signs that people are trying to move before the Fed increases rates sometime in 2015. Fanny Mae and Freddie Mac just announced a loosening of these lending standards, and the banks are already beginning to try to get better returns on their balance sheets.  

Third, central banks are expected to keep interest rates low for an extended period of time, principally because with falling oil prices inflation is not perceived to be a threat, at least if measured by core inflation, which excludes the effects of the volatile food and energy components of the CPI.  But in the US, the focus has been on the labor market and unemployment in particular.  So this points to a lagged reaction to accelerating economic growth by the Federal Reserve, and in other countries such as the UK and Canada as well.  Put another way, it means that the punch bowl might have been emptied but it has still not been removed, now that the party has got going.   Articles in the FT such as this obviously support this idea, and will likely bring forward some house purchases, while at the same time gearing investors up for a rapid rise in rates..

The figure below shows the current dislocation very clearly.  3 month T-bill yields are still almost zero, and yet growth is now above 2 percent. To state the obvious: in every business cycle except the current one, by this stage of the cycle interest rates have been higher.  

Fourth, when oil prices finally go up, they could rise just as fast as they have declined – and the fall in oil prices over the last few months has been dramatic (and the fall is likely not over yet). So if one believes that oil prices will first fall, because of lack of agreement on a coherent strategy in OPEC, then it stands to reason that at some point shale oil projects in the US will get taken offline as they will not be profitable at these low prices, and therefore supply will shrink to meet demand.  But at the same time, and no one really is talking about this aspect of things, lower oil prices mean greater demand for oil.  So in fact, although I would be surprised to see oil prices fall below $45, it would not be completely out of the question, as supply needs to shrink at the same time as plans in other industries reacts to the lower oil prices, stimulating demand. 

The point here is that at some point oil prices could suddenly start to rise again, if for example OPEC suddenly agreed on a strategy to restrict output or if oil prices fell so low that they “overshoot” their new equilibrium value. In a way, this isn’t a bad thing, as the shale oil boom in the US has really gone too far, with drillers just everywhere in my part of the world – airborne pollution now a problem as well, and very little infrastructure to deal with the shipping and refining of these natural resource products.  So, as Schumpeter would say, some “creative destruction” is probably in order here, and lower prices will begin to better align oil demand with supply.  As of Friday, WTI oil closed at just about $63, so if this fall continues, some oil companies will soon definitely be cancelling future projects.

The chart below from BP shows some analysis of what we can expect in terms of the continuing fall in the oil price and how this will translate into lower upstream costs (the cost of oil exploration) down the road. The left panel shows where we are in terms of the fall in oil prices compared to previous rapid oil price declines. Previous declines have settled at anywhere between 50 and 70% declines, so we likely have further to fall yet until some kind of equilibrium is reached.  The period for oil prices to start rising again ranges from 5 months to 16 months, so we could be looking at lower oil prices persisting for a considerable amount of time. The right panel shows that in terms of costs, there appears to be a one year lag before costs fully reflect the fall in the oil price, as projects are cancelled and oil exploration is focuses on more certain and cheaper sources of oil.

How does this situation then potentially set us up for the next recession?  The problem here is that the fall in oil prices effectively stimulates the economy (like a good DJ can stimulate a party), by giving people more disposable income to spend, as filling their fuel tanks becomes a lot less expensive. At the same time, this accelerating growth will not show up as a problem at the Fed and at other central banks, as it gets excluded from their core measures of inflation, and they are still focused on labor market indicators (which are lagging indicators of economic growth).  So the Fed will likely be “behind the curve” when it comes to raising rates, something I believe we are already seeing, as they keep on pushing higher rates further into 2015.  

Moreover, given where government bond yields are, the Fed also appears to be very slow off the mark in terms of reversing QE – yields went up slightly when the bumper labor market statistics were released on  Friday Dec 5th, but came down again very quickly with a few other lackluster economic releases.  Market participants appeared somewhat surprised that bond yields had reacted so little – that in turn tells me that the Fed isn’t selling its bond holdings in any significant numbers, which is something I find quite alarming.

So that sets the stage for a medium term “foot on the accelerator pedal” to really boost growth in the oil dependent countries – notably the North American and European economies. The real problem occurs though when oil prices go back up. This will immediately slow growth, presumably when interest rates are higher, and the central bank meanwhile will be in no mood to be accommodative, as they will be busy trying to “normalize” monetary policy so as to fight any upcoming recession.  This situation though could be the trigger which causes the next economic downturn to occur.  To use the punch bowl analogy once again, this could create a great party, but the hangover could be serious, particularly if the party gets out of hand! 

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.

March Madness, then April Fools, and they didn't go away in May!!

So spring is now over in South Texas as temperatures head back into the 90s and 100s after a colder than usual winter.  But of course the transition from winter to summer is punctuated with March Madness and then the foolishness of April, before the academics and market participants traditionally "go away in May".  This March and April have been particularly crazy, what with more cold weather in March and April, and some really eye popping things going on in the real economy as well as the financial markets.  With bond yields heading lower for no apparent sane reason, I was thinking that this must be an extended bout of March madness and April fools, and that things will correct themselves in May, but alas things have now started to get completely out of hand.

US PPI food (mom): Source BLS

US PPI (yoy): Source BLS

Any economist looking at the PPI numbers released last week for April (see http://www.bls.gov/ppi/ for a breakdown) would interpret this as an uptick in inflation.  The chart taken directly from the BLS website below for year over year producer price inflation shows this.  But what is more surprising is that the food component of the index appears to be definitely showing a spike upwards.  The next chart shows this for the food component of PPI on a month over month basis (2.1%), which comes in at a 5.2% year over year rate.  Now I don't know about you, but I tend to have to eat food, and so this will likely feed through (sorry about the pun) into the CPI pretty quickly, and will affect a whole bunch of things, including supermarket prices, eating out, cruise prices, and anything where food is involved.  

Source: US Treasury website

Now given this, I would have thought that bond yields would have "popped" as a signal (albeit not completely confirmed) that the PPI increases would be a pre-cursor to higher inflation and therefore a quicker move to monetary policy tightening.  But no, bond yields didn't increase, or stay constant, they moved sharply lower. The figure below shows how at the longer end bond yields definitely moved in a downwards direction, while short rates still appear to be anchored at almost zero by Fed monetary policy. This is fast becoming unsustainable as we shift gears to a more growth-inflationary environment. Anyone who has booked an airline ticket, bought a vehicle or been to a supermarket lately knows that prices are definitely moving up as the economy firms.

Now there are some economists who seem to think that the negative Q1 US GDP figures (-1% quarter over quarter at an annual rate) point to an economy teetering on recession or at least in a slowdown or holding pattern.  I think they are dead wrong.  Why?  Well first the way in which the US measures it's economic growth is strange to say the least. I know that -1% shrinkage in the US economy sounds bad, but this is simply due to the compounding of what was a bad weather related quarter.  A more sensible way (which most other countries use) to measure economic growth is to use the year over year change in real GDP.  If we do this, we find that real GDP increased by 2.05 percent - which is not exactly a roaring economy, but it is not bad at all.  Second, with strange weather patterns, it becomes really hard to work out the seasonal adjustments that should be done on the data.  If you use a quarter on quarter measure to assess economic growth, then you have to do seasonal adjustment and any errors are then compounded when you multiply up the figure to an annualized rate.  Using a year over year rate obviates all those problems as you don't have to worry about seasonal adjustment as you are comparing figures from the same season of the year.  

So to the left I have plotted the log change in real US GDP ( - this is just the same as doing a % yoy change calculation).  It is clear that even with the really bad weather that the US economy experienced in the 1st quarter, that the economy is humming along, and in year over year terms, the rate is roughly in line with what we've been seeing for the past couple of years.  

But of course, this means that without the bad weather, the year over year rate might have been significantly higher, perhaps a full 0.5% higher, in which case the economy in fact would have been expanding at it's fastest rate since the last recession ended.  

Now if my view is right, the Fed must be starting to get worried that what it is (not) doing is being misinterpreted as a signal to the markets that it will not move if inflation really does start to move higher as it looks to be doing right now.  When I hear Janet Yellen stating that interest rates will remain low for the next 5 to 8 years, I think some in the market interpret this as easy money for the next 5 years at least, but what they don't seem to understand is that the economy is cyclical. 5 years have now passed since the end of the last recession, so that as we move forward over the next 3 years another downturn becomes more and more likely. In other words, given the history of business cycles we are likely already more than half way through the current growth phase of the business cycle. The Fed therefore will likely have to move fast in order to "normalize" monetary policy so it can be prepared for the next economic downturn.  And in that last sentence you notice that I am not saying "if" it comes - no, it will come alright, and in my next econoblog I will show how some of the research that I am doing looks at these cycles in growth highlights the continuing fluctuations in growth patterns and how they can be interpreted as following a cyclical pattern.

April US interest rate outlook

The Fed minutes were released yesterday (see http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm) and showed that (apart from one member) the FOMC was not worried about inflation quite yet, but it obviously doesn't stop the hawks ruminating on when the current "super-easy" monetary policy will be reversed.  Clearly this is now on the market's mind, and with impeccable timing a  friend recently pointed me to a site http://www.stocktiming.com/Tuesday-DailyMarketUpdate.htm which has an interesting graph of 30-year bond yields breaking out from a 17-year declining trend.  Several comments are in order from a macro perspective.

First, a declining trend cannot continue forever - a break was inevitable, it is the timing that is interesting - we are at a point where clearly the balance of risk is beginning to shift from deflationary pressures to inflationary pressures.  This has clear implications for investors - while the US bond market was a great place to be during the downturn, it will not be such a great place to be anymore!!

Second, the inflation hawks really need to relax - there are so many uncertainties as to how and when the US economy will really pick up steam that it really doesn't make a whole lot of sense to worry about inflation quite yet.  An orderly withdrawal by the Fed and a falling US budget deficit will help to ease pressures as well, so the pressures are likely to be moderate at best.

Third, if this were a short, sharp recession (like the early 1980s recession), then I would say that indeed there is a risk of a strong bounce back which could put the authorities off balance, but given the depth of the recession and the mixed economic signs that we continue to see coming out of it, this looks like it is going to be a slow recovery, which will allow policymakers to make adjustments in a timely fashion which will put the lid on runaway inflation.