With both American and Chinese markets off to an appalling start to the year, public attention has slowly transitioned away from the Fed's historic rate hike. The Dow Jones Industrial Average plunged nearly 10% to 15,998, followed closely by the S&P 500 Index, which dropped 9.22% to 1,880. With investor anxiety further piqued by emerging market weakness, demand for U.S. treasuries notably intensified, with the yield on the benchmark 10-year U.S. Treasury down all the way to 2.03% as its price increased.
S&P 500 & Dow Market Data
On the basis of the January Federal Reserve Minutes, it is evident that the Fed does not overly concern itself with financial market stability-that, however, was far before the sudden influx of abysmal market data. Opposed to the normal concerns with economic trends and momentum indicators such as payrolls and CPI, it is reasonable to believe that recent global market instability will factor into the Fed's aggressive plan for four rate hikes in 2016. Yet to understand how a bevy of weak manufacturing data in China, a strengthened dollar, and easing in Europe will influence the Fed's policy guidance, one must first understand the recent refurbishing of the Fed Funds rate.
Namely, the latest lingo traveling around Fed publications is R*, known as the equilibrium real Fed funds rate. R* describes the real Fed fund's rate consistent with the economy operating at full employment and with inflation at the Fed's target of 2%. Distinct from previous conceptions of the Fed Fund's Rate, there now exists a short run R*, which takes into considerations financial and economic headwinds, and a long run R*, which reflects the real rate absent shocks. With today's economy markedly influenced by tighter credit conditions, overseas instability, contractionary fiscal policy, and a strengthened dollar, the recent Fed minutes revealed that the short-term R* is close to zero. In other words, the current Fed Funds rate range of 25-50 basis points is appropriate based on estimates of short run R*; even more so, it is evident that the four basis point hikes planning to raise the Fed Fund's rate to a 1.25-1.50 basis point range are not even supported by the Fed's own methodology for calculating R*.
Furthermore, it is interesting to note that R* is not a new concept. The idea of a short-term and long-term real interest rate has been explored by economists Thomas Laubach and John Williams, who have performed their own calculations for the respective R* rates. Yet though R* is the newest catch phrase the Fed has adopted, officials continue to use phrases such as the "natural" or "neutral" rate to represent the same equilibrium Fed Funds rate. Predominantly, the natural (or neutral) rate refers to the short to medium term time frame for R*. The reason for its recent adoption lays in the Fed's desire to account for short-term economic fluctuations, while maintaining a consistent vision for future economic growth.
Rather than simply talk about R* in the abstract, it is necessary to ascertain how it will be applied to the Fed's current hiking plan. To put it simply, if the Fed funds rate is below short run R*, then Fed policy is expansionary and promoting growth; on the other hand, if the Fed Funds rate is above short run R*, policy is contractionary. If the Fed is below short run R*, then either the unemployment rate is too high or inflation is not near the Fed's 2% target. However, as discussed above, the current short run equilibrium rate has been identified by the Fed to be near zero; with the selling in China last weak triggering a global downturn in stock market returns, R* clearly has not appreciated since the last Fed meeting. As a result, there is firm reason to believe that the ambitious 4-hike hiking cycle the Fed has adopted cannot be sustained, and that downward revisions will be eminent in the January meeting. Clearly, risks to this perspective include a continued firming of the labor utilization and a return of stability to Chinese markets.
Yet considering that China has rapidly accumulated debt far surpassing its GDP, further risk is posed to the future of Chinese markets and production. In fact, China's foreign currency reserves have dropped by $108 billion in December, a decline far beyond analyst expectations, reigniting concern for a rapid depreciation in the RMB. Should emerging countries (and developed nations) undergo a series of competitive devaluations of their own currency; a far more serious market correction will be in store. Though such a scenario is most likely not a definite future outcome, it is simply explored for the purpose of displaying that the equilibrium real interest rate may be forced to contend with further downward pressure in the future, bringing hiking expectations down to the market's outlook of two hikes in 2016.
Thereby, although the global markets have captivated public attention, it is the subtle changes in Fed lingo that truly warrant importance in the future of economic growth and monetary policy. The sudden changes in the Fed's short-term and long-term perspective of R* demonstrate an even greater need for data-dependency, and the only data radiating from global markets is disaster. Yet before jumping the gun, it is necessary to note that there is still time for conditions to stabilize before the January meeting, and the effective Fed funds rate methodology will be formally introduced all the way in March. Hence, keeping a finger on the market's pulse and an ear attuned to any changes in "Fed talk" will prove to be the standard procedure for the coming month. With theory in mind, we now look to the future for R*'s application.
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