James Bevan: From Fed rates to the euro
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James Bevan
The key message from Fed chair Janet Yellen’s highly anticipated Jackson Hole speech last Friday was that she is joining the chorus of officials who have been saying it is time for another rate hike.
“Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months,” she said.
That seems to be the Fed’s new party line, as recently also expressed by Fed vice chair Stanley Fischer and FRB regional presidents William Dudley (New York), John Williams (San Francisco), Dennis Lockhart (Atlanta), and Loretta Mester (Cleveland).
To make sure that we are left with no reason to be certain about what the Fed will do, she added: “And, as ever, the economic outlook is uncertain, and so monetary policy is not on a pre-set course.”
The second message was that when there is doubt, it’s prudent to simulate.
Mrs Yellen provided a chart of the Fed’s known unknowns. It shows a line tracing the median path for the federal funds rate through the end of 2018 based on the Federal Open Market Committee’s (FOMC) summary of economic projections in June.
Its Figure 1 also shows a shaded region on either side of the line, which is based on the historical accuracy of private and government forecasters. The amazing result is that there is a 70% probability that the federal funds rate will be between zero and 3.25% at the end of next year and between zero and 4.5% at the end of 2018.
Mrs Yellen may be test-marketing this “fan chart” to replace the quarterly “dot plot” of the federal funds rate reflecting the forecasts of the FOMC participants.
‘Buffeted by shocks’
CCLA wish that we could get away with such wide-ranging forecasts. Our latest view is that it will be one-and-done for federal funds rate increases this year and one-and-done next year. That would bring the federal funds rate up to 1.0% by the end of next year. And that might be all for a long time.
In other words, we expect that the process of normalizing monetary policy will be abnormally gradual and limited in scope and duration.
Mrs Yellen provided the following explanation for her approach: “The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted.
“When shocks occur and the economic outlook changes, monetary policy needs to adjust. What we do know, however, is that we want a policy toolkit that will allow us to respond to a wide range of possible conditions.”
Fed officials call that “forward guidance.” In other words, we are on our own. The rest of her presentation was a relatively technical discussion of the subject of her speech titled The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.
In other words, it was addressed to the high-powered monetary intelligentsia in the room rather than the rest of us among the rabble. She reviewed the rather limited pre-crisis toolkit, then the tools that have been added since the crisis. Cutting through the jargon:
- Post-crisis toolkit. Mrs Yellen noted that in 2006, Congress approved plans to allow the Fed to pay interest on banks’ reserve balances beginning in 2011. In the fall of 2008, Congress moved up the effective date of this authority to October 2008.She stated: “… authority was essential. Paying interest on reserve balances enables the Fed to break the strong link between the quantity of reserves and the level of the Federal Funds rate and, in turn, allows the Federal Reserve to control short-term interest rates when reserves are plentiful.”
They certainly were plentiful, as the Fed implemented a series of QE programmes starting in November 2008. Mrs Yellen also touted “forward guidance” as another new post-crisis tool in the toolkit.
- Too close to zero. Until very recently, the Fed was focused on “normalizing” monetary policy very gradually so as not to undermine what seems like self-sustaining economic growth.Now, the Fed is starting to worry about the next recession and whether there will be enough room between the Federal Funds rate and zero to stimulate the economy.
Mrs Yellen observed that most forecasts currently show the Federal Funds rate rising no higher than 3% in the longer run. Between 1965 and 2000, it averaged more than 7%. “Thus, we expect to have less scope for interest rate cuts than we have had historically,” Mrs Yellen stated.
- Why so low? The reason that the Federal Funds rate isn’t expected to rise any higher than 3% is because inflation is expected to stabilize around 2%, while the “neutral” real Federal Funds rate is expected to be only 1% (and 1+2=3!).During past economic expansions, the real rate seemed to be more like 2%–3%.
The real rate is supposed to be the Federal Funds rate minus expected inflation, which is hard to measure.
There are survey data for expected inflation. There is also the yield spread between the 10-year nominal bond yield and the comparable TIPS.
It doesn’t make much sense to use expected inflation over the next several years to inflation-adjust an interest rate that is for funds borrowed and deposited overnight by bankers. We can use the actual core CPI inflation rate instead and the “neutral” real rate, that neither boosts nor slows the economy and has dropped in recent years, according to Fed officials.
As to why that is so and why might it remain depressed, Mrs Yellen offers the following: “Several developments could have contributed to this apparent decline, including slower growth in the working-age populations of many countries, smaller productivity gains in the advanced economies, a decreased propensity to spend in the wake of the financial crises around the world since the late 1990s, and perhaps a paucity of attractive capital projects worldwide.
“Although these factors may help explain why bond yields have fallen to such low levels here and abroad, our understanding of the forces driving long-run trends in interest rates is nevertheless limited, and thus all predictions in this area are highly uncertain.”
Or, as Stanley Fischer recently stated in his 21st August speech on the slowdown in productivity: “We just don’t know.”
Indeed, no one even knows if the neutral real rate concept makes any sense and some critics of the Fed and other central banks have observed that by keeping interest rates near zero, monetary policy may be an important source of secular stagnation, which is why the real rate is so low.
Savers are earning less and are forced to save more. Corporations are using cheap money to buy back their shares rather than invest. Zombie companies that should be out of business are able to stay in business by refinancing at low rates and keeping their excess capacity on line, depressing prices and profits.
And on the fiscal side, a significant portion of the government’s budget deficit is financing entitlement programmes rather than infrastructure spending. The monetary authorities are enabling the fiscal authorities to do this at very low interest rates. Burdensome taxes and regulations may also be contributing to secular stagnation in the US and around the world.
- Fun with econometric models. When reality bites the forecasts of macroeconomists, they don’t curl up in a ball and mutter quietly to themselves in the corner.Instead, they simulate reality with their econometric models and show why they are right after all, at least in their simulated world.In her speech, Mrs Yellen acknowledged that a 3% Federal Funds rate (assuming that it ever gets there again in our lifetime) may not leave enough room to ease during the next average-style recession, based on previous experience.A recent Fed working paper is reassuring, at least to Mrs Yellen. It is by David Reifschneider and titled Gauging the Ability of the FOMC to Respond to Future Recessions. Its conclusion is very reminiscent of arguments made by both William Dudley and former Federal Reserve chair Ben Bernanke for QE2 during November 2010.
They both said that the Fed’s econometric model showed that the Federal Funds rate needed to be lower than zero. But the Fed’s mantra back then, and now, is that zero is the “zero bound.” Negative interest rates remain off the table (for now).
Back in 2010, the Fed’s model showed that a negative 0.75% Federal Funds rate was needed and that it could be accomplished, in effect, with QE2 purchases of $600bn in Treasury bonds.
Mr Reifschneider’s latest iteration of this exercise comes up with the same conclusion: if the Fed’s econometric model shows that the Federal Funds rate should be lowered below zero during the next recession, that can be achieved effectively with another QE move and more forward guidance.
Mrs Yellen admits that these tools might be pushed to their limits if the Federal Funds rate gets up only to 2% rather than 3%. In any event, the Federal Funds rate currently is only 0.25%-0.50%, and may or may not be up to 0.50%-0.75% by the end of this year.
- Other options. Mrs Yellen is reaching out to her staff and other economists for more tools to run monetary policy and interestingly, in her speech, she didn’t mention negative interest rates. She did mention that QE purchases could be broadened to other assets, which could include corporate bonds and equities, but she didn’t say.Mrs Yellen did mention raising the 2% inflation target, as some economists have advocated, but that looks bonkers given that the Fed can’t even get it up to 2%. She also mentioned that fiscal policy could play a role, but stayed clear of suggesting so-called helicopter money.
- Unreal rate. On the neutral rate concept and why Fed officials are suddenly so obsessed with it, Stanley Fischer explained in his 21st August speech: “… there have been other issues of concern to those particularly interested in monetary and macroeconomic policy, though probably of less explicit concern to the public: the decline in estimates of r* — the neutral interest rate that neither boosts nor slows the economy — which is related to the fear that we are facing a prolonged period of secular stagnation; the associated concerns that (a) the short-term interest rate will be constrained by its effective lower bound a greater percentage of time in the future than in the past, and (b) that the US economy could find itself having to contend at some point with negative interest rates —something that the Fed has no plans to introduce; the fear that very low interest rates present a threat to financial stability; and concerns that low rates of real wage growth are increasing inequality in the distribution of income.”
If we look at the relationships between the real Federal Funds rate (using the current core CPI inflation rate) and the variables mentioned by Mrs Yellen as possibly explaining why the real rate is low, it’s hard to see much when comparing the real rate to the growth rate of the US working-age population, US productivity growth, the US personal saving rate, and the capacity utilization rate.
Conclusions
The conclusions we draw are that interest rates will stay low relative to the experience of the post-War period, that over-capacity will remain an issue, and that in this environment “quality growth” focused real assets look well placed.
Meanwhile, the US monetary data remain strong, but with virtually all of the increase in credit that is occurring within the economy seeming to flow towards the asset markets. In the near term, this may support asset markets even while the real economy remains “crowded out”.
With Japan, the latest monetary data have on balance been weaker but Haruhiko Kuroda, governor of the Bank of Japan (BoJ), failed to say much that was new at Jackson Hole: helicopter money remains off the agenda; the issue of what to do when the stock of Japanese government bonds available for the BoJ to buy runs out remains unresolved; and the Bank will continue to set policy according to its interpretation of the economic situation.
As for Euroland, at a headline level, the aggregate credit data for July were disappointing in that both credit growth rates slowed and monetary growth remained anaemic.
One positive development was that the reduction in bank asset growth allowed the banking system to become a little less dependent on the TARGET2 system.
While the latter was clearly a positive development, what this situation implicitly reveals (yet again) is that the assets of the European banking system seem to be only able to expand when the TARGET2 system is expanding and vice versa; and we seem to have reached a situation under which the ECB has to provide both the assets (i.e. the bond purchases) and the liabilities (TARGET2 funding) for any expansion of the aggregated balance sheet of the European banking system.
Of course, while the European Central Bank can sustain this system, inefficient though it may be, the euro can survive from a mechanical point of view but whether Europe’s citizens will be prepared to live with the consequences of this for much longer remains to be seen.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
