The Fed Hasn't Yet Begun To Tighten

by: Calafia Beach Pundit

Today we'll likely learn that the Fed is raising its target Funds rate (and the rate it pays on excess reserves) by another 25 bps, to 2.0%. It won't be surprising, and it shouldn't pose any threat to financial markets. That's because this latest hike is necessary just to keep monetary policy "neutral." In fact, the Fed has been in neutral for the past year. How is that? Because the economy has been gradually picking up steam over the past year, and inflation is up as well. A modest pickup in growth and a modest rise in inflation fully justify a modest rise in rates. Indeed, it would be worrisome if the Fed doesn't raise rates today.

Chart #1

Chart #1 is an update of a chart I've been following for years. It shows that over time there is a correlation between the pace of real economic growth and real interest rates. Very strong growth (4-5%) in the late 1990s was matched by very high real yields (4%). Since then the economy has been downshifting, with growth in the current business cycle averaging a little over 2% and real 5-yr yields meandering around zero. Growth has picked up of late, however, and so have real yields. Current estimates for Q2 growth are roughly 4%, and if that proves to be the case, then real growth over the past year will have been about 3%. (The chart shows the 2-yr annualized growth rate, to better track the recent "trend" which I project will reach 2.6%.)

If growth continues to accelerate, as I expect it will (but the market is not yet convinced of this), then real yields could rise to the 2-3% range in a few years. That would of course imply a lot more Fed rate hikes than the market is currently expecting.

Chart #2

Chart #2 compares the real yield on 5-yr TIPS to the real, inflation-adjusted Fed Funds target rate - which is the only rate that really matters to the markets and the economy. I've projected the real Funds rate to rise to about 0.1% by the end of this month. Note that the real Funds rate has been relatively stable for the past year; 3 rate hikes have been necessary simply to offset the rise in inflation.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS with the "Natural Real Rate" as calculated by the Laubach-Williams method. This is "the rate interest rate consistent with output equaling potential and stable inflation." In short, it's one way of estimating what the real Fed Funds rate should be if the economy is operating at or near its potential and inflation is stable. Note that 5-yr real yields (which can be thought of as the market's forecast for what the real Fed Funds rate will average over the next 5 years) are effectively projecting that the Fed will "tighten" monetary policy only moderately over the next several years, in a manner consistent with inflation remaining stable and the economy picking up a little speed. The Natural Rate should rise as the economy picks up speed.

Chart #4

Chart #4 compares the real Funds rate with the Natural Real Rate. It's likely that the Fed keeps an eye on the natural rate, and manages the real Funds rate accordingly. If they need to "tighten" policy they push the real Funds rate above the natural rate, and if they need to "ease" (as they did for most of the current business cycle), then they push the real rate below the natural rate. The two lines converged in June of last year, which can be interpreted to mean the Fed decided in early 2017 that the economy no longer needed policy "stimulus," and therefore monetary policy should shift to neutral. (I'm not endorsing this way of thinking, merely commenting on how it might work.)

Chart #5

It's worth repeating Chart #5, to make the point that it takes very tight money policy to precipitate a recession. Tight monetary policy shows up in the form of very high real short-term rates and a flat or inverted yield curve. We're a long way from seeing those two conditions repeat. The current shape of the yield curve is still upward-sloping, which means only that the market expects the Fed to continue to raise short-term rates for the foreseeable future. That's not remarkable or in the least scary. Besides, real interest rates are still unusually low.

Chart #6

Chart #6 compares the nominal and real yields on 5-yr Treasuries, with the bottom line being the difference between the two, which is the market's implied forecast for what the CPI will average over the next 5 years. Happily, inflation expectations are only slightly above 2%, which is fully consistent with the Fed's objectives and fully consistent with stable inflation. If the Fed is going to hike rates significantly, we'd first have to see stronger growth and/or rising inflation expectations.

Chart #7

The CPI ex-energy, shown in Chart #7, has actually been very stable around 2% for the past 15 years. I justify taking out energy prices because they are by far the most volatile of all commodity prices, and it makes no sense for the Fed to try to control energy prices. And in the long run, there is not much difference between the full CPI and the ex-energy CPI.

Chart #8

Chart #8 shows the history of the CPI and the ex-energy CPI, using a 6-month annualized calculation to focus on recent trends. Note the huge amount of volatility imparted to the full CPI just by adding energy prices, even though energy represents less than 4% of personal consumption expenditures. Over the past 20 years, the full CPI has averaged 2.2% per year, while the ex-energy CPI has averaged 2.0%.

Chart #9

One of the least-remarked developments on the inflation front is arguably the disappearance of deflation from computer prices. Chart #9 shows how prices for computers and peripherals were falling 30% per year about 20 years ago. So far this year, prices have been stable, for the first time ever.

Chart #10

One reason to expect stronger economic growth is shown in Chart #10. Small business optimism has never been higher than it is today. Entrepreneurs are excited about lower tax rates and a substantial reduction in regulatory burdens. This should translate into more investment, more jobs, and higher productivity (which has been sorely lacking during the current business cycle).

Chart #11

Chart #11, another perennial favorite, shows how every major increase in the market's level of concern and uncertainty has coincided with a sharp selloff in equity prices. Once fears subside, prices float back up. The same cycle has repeated a number of times in recent years, and we're at the tail end of the most recent.

Chart #12

Chart #12 compares the Core measure of consumer price inflation (ex-food & energy) with 5-yr Treasury yields. Normally the two should move together. That relationship broke down in 2011, however, when the market started worrying about the collapse of the eurozone, the fiscal cliff, China, oil prices, Brexit, and the US election, successively. Risk aversion throughout most of the current business cycle drove strong demand for Treasury yields, keeping them unusually low relative to prevailing inflation. Now we're getting back to normal. Higher interest rates are not scary, they're to be expected.

I don't think the Fed is going to be a source of concern for the market for the near future. But if the economy heats up, the Fed governors are going to be wringing their hands and losing sleep at night. And if inflation expectations rise, well, then we'll all start to worry. But for now the main thing to watch is the economy, which should continue to show signs of faster growth. (See my last month's post "Waiting for GDP") If I'm right and GDP growth accelerates convincingly above 3-3.5%, then the Fed is going to have to raise short-term rates, and bond yields are going to have to rise as well, and both by much more than the market is currently expecting. Will higher interest rates kill the economy? No, because they will be the natural result of a stronger economy. Interest rates will only become a concern when the Fed thinks it needs to step on the brakes and raise real rates significantly.