Misreading the Tea Leaves – the Fed Policy Shift
The Federal Open Market Committee (FOMC) meeting this past week was practically a non-event – a 25 basis point rate hike long telegraphed, the reassurance of a slow and steady Fed to bring interest rate back to the normal level, and the subsequent celebration of the markets. The corporate media press corps dutifully covered this monetary non-event: We came, we saw, she raised.
Except for a seemingly awkward exchange between Fed chair Janet Yellen and Bloomberg’s Kathleen Hays during the question period.
Hays posted a question which anyone with a most rudimentary understanding of economics, let alone the army of sell-side market pundits who opine to market participants and the masses for a living, would have scratched his head and thought out loud: “Does not compute”.
Hays asked Yellen why the hike in the face of tangible evidence that the economy is seriously gearing down. In order words, the Fed has been saying all along that they are data dependent. Now the data says the economy sucks and yet the decision to hike.
I guess my question is this: In another sense, what happened between December and March?
GDP is tracking very low. Measures of labor compensation are not threatening to boost inflation any time fast. The consumer is not picking up very much. Fiscal policy, we don’t know what’s going to happen with Donald Trump. And yet, you have to raise rates now. So what is the — what is the motivation here? The economy is so far from your forecast in terms of GDP, why does the Fed have to move now? What does this signal, then, about the rest of the year?
To which Yellen responded:
So GDP is a pretty noisy indicator.
If one averages through several quarters, I would describe our economy as one that has been growing around two percent per year. And as you can see from our projections, we — that’s something we expect to continue over the next couple of years.
Now, that pace of growth has been consistent with a pace of job creation that is more rapid than what is sustainable if labor force participation begins to move down, in line with what we see as its longer-run trend with an aging population.
Now, unemployment hasn’t moved that much, in part because people have been drawn into the labor force. Labor force participation, as I mentioned in my remarks, has been about flat over the last three years. So in that sense, the economy has shown over the last several years that it may have had more room to run than some people might have estimated, and that’s been — that’s been good. It’s meant we’ve had a great deal of job — job creation over these years.
And there could be — there could be room left for that to play out further. In fact, look, policy remains accommodative. We expect further improvement in the labor market. We expect the unemployment rate to move down further and to stay down for the next several years. So we do expect that the path of policy we think is appropriate is one that is going to lead to some further strengthening in the labor market.
Did you get that? Didn’t think so.
If one has taken verbatim the Fed’s evolving narratives which have been dutifully reported and spun by sell-side pundits, one can be forgiven for being confused about the convoluted and content-free answer to a seemingly innocent question.
But if you understand the underlying dynamics, everything becomes clear. The emerging reality is re-asserting itself, something the stock market has definitely not priced in.
Forget about the ‘data dependent’ gobbledygook roundabout non-answer, here are some crucial factors which govern the realities on the ground:
- The Fed and the rest of the central bankers have been on an ultra-accommodative monetary policy since the global financial crisis, bringing interest rates down to zero and even negative in order to save the private banking system.
- The Fed should have embarked on removing some of the excess liquidity years ago but chose not to. They have completely missed the boat and are now seriously behind the curve.
- The so-called recovery has been long in the tooth, and all economic indicators are pointing toward a slowing economy despite the tsunami of liquidity injected into the system and a next recession cycle is already overdue.
- In a typical recession, it takes the Fed lowering interest rates by 3 percent to stimulate the economy out of recession. The Fed rate is currently under one percent. The Fed is out of interest rate ammo if a recession hits how. Even at a measured pace of 25 basis points four times a year, it would take about three years to reload its pistol.
- The zero interest rate policy (ZIRP) and quantitative easing programs, ostensibly to save the economy from collapse, are designed, first and foremost, to save the private banks which would have collapsed. However, by flattening the yield curve, ZIRP is also decimating the very banks’ business model which is making money from the yield spreads by lending long and borrowing short. The Fed is under a lot of pressure from the private banking system to raise rates and steepen the yield curve.
- The fact that there is no love lost between Trump and the current Fed is not news – Trump had claimed during the election campaign that the Fed kept interest rates low to help his opponent during the election. Seeing that Trump is in a position to replace four of the seven Fed board members in the next two years and Yellen looking at her own potential early retirement party in early 2018, it is not inconceivable that the outgoing members might give the new president what he is asking for and ‘do the right thing’.
Based on the above premises, here’s a short and sweet translation of Yellen’s response and a hint of the underlying policy shift:
Forget data dependent. We will continue to hike as fast as possible as long as (1) the economy does not get pushed into recession and (2) the capital markets do not come crashing down.
Judging from its reaction – shrugging off the hike and maintaining its belief of a continued accommodative Fed – the markets seem to have either failed to detect this definitive policy shift or are too overwhelmed by the latest blow-off euphoria to notice the hint. After all, less than a third of the pundits were predicting this latest rate hike as recent as 40 days ago.
Once the realization of a new Fed path takes hold, the re-pricing as a result of the reckoning by the markets would be quite something to behold.