Fed Yet To Fully Embrace A New Policy Path

by: Tim Duy

The Fed will take a pause on rate hikes. An indefinite pause. The sooner they admit this, the better off we will all be. Indeed, the sooner they admit this, the sooner financial markets will calm and the sooner they would be able to resume hiking rates. Federal Reserve Chair Janet Yellen had two high profile opportunities this week to make such an admission. Yet she failed to do so. She gave some ground on March, to be sure. But overall, the Fed just isn't ready to stop talking about rate hikes later this year.

The framework from which I consider the Fed's current predicament begins with this chart:

FED021116 Beginning in 2013 and extending through most of 2015, the domestic side of the US economy surged as consumer spending accelerated, investment stabilized, and government spending gained. The trade deficit acted as a pressure valve, widening to offshore some of the domestic demand. On net, economic activity was sufficient to collapse the output gap. By the end of 2015, the economy was near full-employment.

At full-employment, a combination of factors would work in tandem to slow activity to that of potential growth. I think of it as a new constellation of prices consistent with sustained full-employment. I can't tell you exactly what the new constellation would look like other than the most likely combination: A mix of higher dollar, higher inflation, higher wages, and higher short term interest rates (tighter monetary policy).

How much monetary policy tightening is consistent with the new equilibrium depends on the evolution of the other prices. A reasonable baseline at the end of last year was that 100bp of tightening would be consistent with achieving full-employment. That was the Fed's starting point as well.

The international interconnectivity of financial markets, however, dealt a blow to the expectation of even a gradual rate increase. The actual and expected policy divergence between the Federal Reserve and the rest of the world's major central banks drove a rally in the dollar. That unexpected strength of that rally means that some other price has to move accordingly to sustain full employment. The most likely price is short-term interest rates. That's the signal from the collapse in long rates. That signals the Fed will be lower for longer, reducing the magnitude of the policy divergence, and allowing the dollar to retreat.

Ironically, I suspect the Bank of Japan's foray into negative interest rates sealed the fate of the divergence trade. First by pushing market participants into US Treasuries, signaling that the Fed would need to respond to the BOJ by reducing the expected short-term policy path. Second by killing bank stocks. Market participants in the US were already primed by Fed Vice Chair Stanley Fisher that negative rates could be a policy tool. And this point was seconded by Yellen this week.

But the collapse in banking stocks suggests strongly that negative interest rates are not compatible with our current economic institutions. The system relies on the banks, and the banks need to make money, and they struggle to do so in a negative rate environment. Should it be any surprise that the threat of global negative rates is slamming the financial sector?

If then zero (or something just below zero) is indeed a practical lower bound, and all major central banks are pulled in that direction, then the scope for policy divergence is limited. Again, this suggests the policy divergence trade - a one-way bet on the dollar - is nearing the end if not already there. It had to end sooner or later. A one-way bet would eventually cripple the US economy.

In sum, a key factor in keeping the US economy on the rails is acknowledging that tightening financial conditions via the dollar obviates the need to tightening conditions via monetary policy. This will also sustain the expansion and allow wage growth and inflation accelerate. The Fed can stand down, and let my scenario five evolve. All of this is well and good, but the Fed has yet to fully embrace this story. And that leaves them sounding relatively hawkish. Yellen's testimony continues to emphasize that the Fed expects to keep raising rates. To be sure, she includes the data dependent caveat, and this:

Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar.

should be sufficient to take March off the table despite solid labor data. But the underlying message is that they expect higher rates. It is only the pace that changes, not the direction. There is just no reason to promise higher rates. All the Fed needs to say is:

"Monetary policy will be appropriate to achieve the Fed's mandate."

Yellen & Co. don't need to emphasize the direction of rates. They just can't stop themselves. Worse yet, they feel compelled to describe the level of future rates via the Summary of Economic Projections. A level entirely inconsistent with signals from bond markets, no less. They don't really know what the terminal fed funds rate will be, so why keep pretending they do? The "dot plot" does nothing more than project an overly-hawkish policy stance that leaves market participants persistently fearful a policy error is in the making. It is time to end the "dot plot."

It might be helpful to add:

"We will not pursue negative interest rates if such a policy is incompatible with stability in financial sector."

They should stop with the random and partially considered talk of negative interest rates. Instead, adopt a basic talking point indicating the idea has yet to be thoroughly vetted and as such any speculation on the topic is premature.

Bottom Line: The Fed has yet to fully embrace the change in financial conditionals and the implications for the path of policy. To be sure Yellen gave enough this week to take March off the table. That said, policymakers will hesitate to dramatically change their general policy outlook focused on higher rates. Consequently, I anticipate Fedspeak with seemingly unrealistic hawkish undertones. Essentially, they will leave the fear of policy error simmering on the back-burner.