Monetary Policy Outlook: The United States (Fall 2017)

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Includes: BIL, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RINF, RISE, SCHO, SCHR, SHV, SHY, SPTL, SPTS, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UDN, USDU, UST, UUP, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Brad DeLong

What Will (Probably) Happen?

  • What the Federal Reserve thinks:

    • that the U.S. economy is near full employment...

    • that U.S. potential-output growth rate is 2%/year...

    • that it should be "normalizing" interest rates...

  • A positive shock to growth (or inflation) will see the Fed raise faster and further:

    • Do not expect real growth much above 2%/year under this Fed...

    • Do expect the Federal Funds rate to rise at about (3/4%/year)/year -or faster - as long as the economy can stand it without recession...

    • A negative shock to inflation will see slowed but not stopped "normalization"...

  • A negative shock to growth will see:

    • The Federal Reserve quickly return the Federal Funds rate to zero...

    • And then dither, with many tools but none of them powerful to affect the economy…


Employment-to-Population, 25-54

  • I think the Fed could be more aggressive at promoting growth…

  • Prime-age employment-to-population numbers in the U.S. still show considerable labor market slack…

  • But the unemployment rate shows over-full employment…

  • Wage growth shows no labor supply-side pricing power for workers…

  • Yet the Federal Reserve trusts the unemployment rate much more than other indicators…

    • This creates a puzzle because…


Inflation Remains Subdued

  • Back in the 1950s Alan Greenspan declared that 2%/year measured inflation was "effective price stability"…

  • The Bernanke-Yellen Federal Reserve decided to use the core PCE chain index…

  • Persistent undershoot:

    • Since January 2009, cumulating to 4%-points in the price level…

    • Recent price news not suggesting any inflationary spiral developing soon…

  • Suggesting that the tightening cycle announced in mid-2013 and begun in 2016 was premature…

    • The market agrees with me…


The Long Nominal Rate, Inflation Breakeven, and Long Real Rate

  • When Larry Summers was Deputy Treasury Secretary, he convinced Bob Rubin to issue TIPS…

    • We now have 15 years of watching the long nominal rate, long real rate, and the difference between them:

      • The expectations based inflation breakeven…
    • These give us a better window…


Secular Stagnation

  • Fall in (notional) TIPS from 4% at end of 1990s to 2% in mid-2000s…

  • Fall in TIPS from 2.0-2.5% pre-crisis to 0.0-0.5% today…

  • Without any signs of a runaway boom of any sort…

    • But increased appetite for debt…

    • Any risks being generated?


Implications for the Fed-Controlled Short Rate and the Long Rate

  • The Federal Reserve controls the interest rate on Treasury bills…

    • Subject to the condition that it cannot drive it below zero (without making substantial institutional changes in the banking system)…

  • The long rate goes where it wants…

    • And it has not wanted to go up for a long time indeed…

    • Expect a lot of time at the zero lower bound over the next decade…


Might We Get a Different Fed?

  • I said "under this Fed"…

  • But might we get a different Fed?

    • Very unlikely…

    • Trump not interested…

    • The non-unitary executive:

      • Will appoint Republican monetary-policy worthies
      • Most of whom think like the Fed already…
      • And the Fed is very good at assimilating new governors and bank presidents…

Summing Up

  • I said that under this Fed:

    • If no recession:

      • A ceiling of 2%/year on growth…
      • A ceiling of 2.5%/year on inflation…
      • Short-term interest rate increases of (3/4%/year)/year or more…
        • Already priced into long rates…
    • If recession:

      • Cut Fed Funds rate back to zero…
      • Dither…

Implications for Trading Partners

  • U.S. not a locomotive for demand...

  • U.S. not a (major) source of likely upward demand or upward interest rate shocks...

  • Trading partners have to decide how to react to the tightening cycle:

    • But it will be slow (probably)...

    • Hence (probably) innocuous...

  • Trading partners do have to worry about a recession in the United States:

    • Given the absence of powerful monetary policy tools to the Fed's hand...

    • Given the lack of political will for non-monetary stimulus...