I already wrote about central bank credibility issues in an earlier post. The Fed is sending mixed messages and creating confusion to the point that the market has been ignoring Fed talk more and more. Others have this issue, with the “elephant in the room” being the Bank of Japan’s now-ridiculous 2% inflation target that it completely ignores. Here is why the Fed seems “a little confused.”
The “warning” cycle
For quite some time now, the Fed has been in “slight tightening bias” with interest rates. Yet FOMC members are increasingly split and we have the impression that there is some duality within most members about the path of rates going forward.
A tightening bias emerges when there is growing perception of the economy approaching potential, which generally creates upward price pressure, inflation, and rising inflation expectations. When this happens, you see core inflation rising, unemployment dropping, production capacity maxing out, and a shortage of labor.
To prevent “overheating” and the dreaded “disanchoring” of inflation expectations, the central bank starts to gradually “put the brakes” so that economic activity gradually sets into a comfy speed that keeps actual production close to potential, unemployment close to the “natural” rate, without a big inflationary push while avoiding a deflationary crash.
For a given inflation target (of 2% - we’re all so original!), the central bank conducts monetary policy with a dynamic path for rates in mind: they have a path for the evolution of short term rates that feeds and is fed by their models and their own assessement of what is happening.
A purely “robotic” interest rate setting model would be based on a Taylor Rule: for a given inflation target, you would set the Fed Funds Rate based on where inflation (core or total or a mix of both) is relative to the target, where unemployment and production are relative to potential, and where the world real interest rate sits (very low right now and for a very long time to come).
Here is the path suggest by the Taylor Rule, with the actual Fed Funds Rate decided by the Fed:
As you can see, the Fed was more dovish than the Taylor Rule between 2003 and 2007 and seemingly more hawkish between 2009 and 2011, but that is because they stopped at zero and went into massive QE. Factoring in QE, Fed monetary policy was not “tighter” than suggested by the Taylor Rule.
Decisions about the path for interest rate don’t follow robotic rules becausre there is more complexity and global market aspects to take into account than what the simplistic Taylor Rule suggests, which is why you should take this rule as a general guide, but nothing else.
The neutral rate
If things are “normal” in the economy, you would expect the Fed Funds Rate to be roughly this: world real interest rate + expected inflation + some risk, which depends on the country and context. Supposing the USD is a safe haven and that world markets are relatively riskier than the US market, you can pretty much set the risk to zero. That leaves us with i = r + expected inflation as the neutral rate. What is the current “r” and what are inflation expectations?
Given that most of the industrialized world is at roughly 0% inflation and 10 year bond yields are between 0 and 2%, we can go ahead and say that the world real interest rate is very low, perhaps as low as 0%.
What about expected inflation in the USA? Here is the expected inflation rate that the market expects 5 years from now, for 5 years later. In other words, most of the market expects that inflation in 5 years will have a very low outlook for the future:
So the market has been decreasing its expectations about future inflation, and THAT is one thing that is holding the Fed back.
Where would that put the neutral rate. Well if the economy was running at potential, the neutral rate would be i = r + expected inflation = 0 + 1.6 = 1.6%.
The issue is that the US economy is not necessarily running on potential, which means some Fed officials feel that the rate must remain below 1.5% to remain expansionary. No problem of course, it sits comfortably below that… BUT the “psychological” effect of a rate hike is what the Fed is worried about, which could tip inflation expectations even lower and bring the Fed dangerously close to debt-deflation dynamics in the face of any negative shock… not good…
Increase rate to get further fro zero?
There really is no special hurry to increase rates anywhere, honestly. Growth is weak, core PCE inflation is at 1.6%, participation rate and employment rates have yet to recover at least a bit from the Great Recession (it’s not all demographics), there is no sign of overheating and an explosion of inflation around the corner.
Other than to tame inflation, there are 2 issues that make central banks want to raise rates. The first is simply to be comfortably above zero so that there is room to cut rates if an advserse shock hits the economy. The second is financial bubbles, which occur in a super-low-rate-context that creates easy and massive money looking for yield. But central banks generally prefer to not do this because this would be implicitly adding a mandate to monetary policy (preventing bubbles), which is really the job of regulation and financial market oversight with macro prudential policies. Some central banks also have a third issue for changing rates, which is the value of the currency, but that is not the case for the Fed.
A higher inflation target?
John C Williams, the President of the San Francisco Fed recently mentioned the possibility to increase the inflation target to increase average “normal” interest rates and avoid falling into deflation due to a shock, which would add “padding” between “i” and zero and allow the economy to return faster to full potential after a shock due to the fall in real wages and a return to labor market equilibrium.
A “reflation” campaign would require temporarily more expansionary monetary policy, to pump up inflation and inflation expectations. This means lower interest rates for a while, followed by higher average interest rates in the long term.
Conflicting messages and fuzzy communications
A goal for higher inflation would require lower rates. Falling inflation expectations, sluggish growth, and low core PCE inflation suggest a need to cut rates. Yet, the Fed is warning of rate hikes… to prevent bubbles? To move away from zero? In a hurry to normalize rates? (whatever that means). Rate cuts would be bearish for the USD. Rate hikes would be bullish for the USD.
One thing that is holding back the Fed is the synthetic measure of labor market conditions, which recently turned positive but still remains on the low side:
The source of fuzzy messages
At least now you know where the fuzzyness comes from: some members of the FOMC find that it is time to “normalize” rates and let structural forces take over to allow the process of growth to resume without stimulus… Other FOMC members are looking at inflation, inflation expectations, the world real interest rate, employment and participation rates, the world economy, and are in no hurry to hike rates. All members are aware of the potential for bubbles. The net effect of all this is confusion… But at least we are clear about the confusion J
What are your thoughts on this?