The following is a set of points to consider when thinking about how the Fed should conduct monetary policy going forward. This is by no means an exhaustive list and is solely meant to stimulate discussion after a somewhat sleepy summer in the financial markets despite what was an intense international political backdrop.
1. The aggregate macro data has been mediocre.
In Q3 2014, the rate of US nominal GDP growth reached 4.9% (YOY). A few months later in Q1 2015, the pace of RGDP reached 3.31% (YOY). In anticipation of these relative growth rate highs, the 10 year treasury yield topped roughly 3% in January 2014. Since that point, NGDP and RGDP have slowed to 2.43% and 1.6% respectively (Q2 2016). Although the 10 year treasury yield may have at least temporarily bottomed, as of today it stands at around 1.6%. Between these periods, the dollar index rallied 20% (trendless since the beginning of 2015).
Corporate profits also topped out between 2011-2014. This decline in corporate earnings relative to GDP wouldn't be as problematic had this rise in labor share of income (obverse of the latter) been driven by accelerating aggregate income growth. If the fall in corporate profits amid decelerating NGDP were to continue, one wonders at what point would firms respond by reducing their pace of hiring (or worse) in order to cut costs to protect profit margins.
Although the Fed advertised a steeper path for the fed-funds rate following the December 2015 rate increase, as 2016 wore on their view converged with the more gradual expectations set forth by market participants. Consequently, the dollar which rallied ahead of the Fed's December 2015 decision remained muted for much of this year. Given that the dollar surge squeezed firms, this reprieve enabling corporate earnings to rebound for the moment.
1. The aggregate macro data has been mediocre.
In Q3 2014, the rate of US nominal GDP growth reached 4.9% (YOY). A few months later in Q1 2015, the pace of RGDP reached 3.31% (YOY). In anticipation of these relative growth rate highs, the 10 year treasury yield topped roughly 3% in January 2014. Since that point, NGDP and RGDP have slowed to 2.43% and 1.6% respectively (Q2 2016). Although the 10 year treasury yield may have at least temporarily bottomed, as of today it stands at around 1.6%. Between these periods, the dollar index rallied 20% (trendless since the beginning of 2015).
Corporate profits also topped out between 2011-2014. This decline in corporate earnings relative to GDP wouldn't be as problematic had this rise in labor share of income (obverse of the latter) been driven by accelerating aggregate income growth. If the fall in corporate profits amid decelerating NGDP were to continue, one wonders at what point would firms respond by reducing their pace of hiring (or worse) in order to cut costs to protect profit margins.
Although the Fed advertised a steeper path for the fed-funds rate following the December 2015 rate increase, as 2016 wore on their view converged with the more gradual expectations set forth by market participants. Consequently, the dollar which rallied ahead of the Fed's December 2015 decision remained muted for much of this year. Given that the dollar surge squeezed firms, this reprieve enabling corporate earnings to rebound for the moment.
Therefore even without factoring in the trend in global NGDP and the role of the eurodollar markets, can it be argued that US monetary policy has been too tight? At the very least, should the Fed refrain from speaking too hawkishly until those aforementioned trends reverse materially?
2. The Fed has consistently missed on their duel mandate throughout the recovery.
Seeing as the Fed is considering another policy rate increase in 2016 despite years of missing their inflation target to go along with slowing NGDP, RGDP, corporate earnings, and gross domestic investment growth, is it really unreasonable for market participants to perceive the Fed's 2% inflation target as a ceiling? One also must take into account where the price level and by extension NGDP would be had the Fed successfully been hitting their inflation target.
Given that the Fed has consistently undershot their inflation target, moving now may signal that they are overreacting to the employment side of their dual mandate. As Governor Lael Brainard has recently state, the Fed risks overstating the strength of the labor market. In her words (emphasis mine),
Seeing as the Fed is considering another policy rate increase in 2016 despite years of missing their inflation target to go along with slowing NGDP, RGDP, corporate earnings, and gross domestic investment growth, is it really unreasonable for market participants to perceive the Fed's 2% inflation target as a ceiling? One also must take into account where the price level and by extension NGDP would be had the Fed successfully been hitting their inflation target.
Given that the Fed has consistently undershot their inflation target, moving now may signal that they are overreacting to the employment side of their dual mandate. As Governor Lael Brainard has recently state, the Fed risks overstating the strength of the labor market. In her words (emphasis mine),
"In addition, the unemployment rate is not the only gauge of labor market slack, and other measures have been suggesting there is some room to go. The share of employees working part time for economic reasons, for example, has remained noticeably above its pre-crisis level. Of particular significance, the prime-age labor force participation rate, despite improvement this year, remains about 1‑1/2 percentage points below its pre-crisis level, suggesting room for further gains. While it is possible that the current low level of prime-age participation reflects ongoing pre-crisis trends, we cannot rule out that it reflects a lagged and still incomplete response to a very slow recovery in job opportunities and wages.6
This possibility is reinforced by the continued muted recovery in wage growth. Although wage growth has picked up to about a 2-1/2 percent pace in recent quarters, this pace is only modestly above that which prevailed over much of the recovery and well below growth rates seen prior to the financial crisis.7
My main point here is that in the presence of uncertainty and the absence of accelerating inflationary pressures, it would be unwise for policy to foreclose on the possibility of making further gains in the labor market."
As a way to better balance both inflation and employment objectives, will we see the Fed and other major CBs replace inflation targeting regimes with NGDP level targets at some point in the future? Wouldn't the Fed be better protected politically when dealing with the nominal demand shortfall if they were speaking much more in terms of the domestic economy's need for faster aggregate spending/income growth rather than inflation (which is at best a necessary side effect of an economic expansion)? It would be far more difficult for critics to fault the Fed for trying to boost domestic income growth, whereas communicating in the language of ("needing") inflation makes it a much easier target.
Boston Fed President Eric Rosengren has recently reiterated the case for the Fed to tighten monetary policy in order to avoid a situation where potential future financial excesses cause the economy to overheat. In this scenario, the Fed would be forced to tighten quickly which could jeopardize the employment gains made following the recession. Therefore, a preemptive tightening bias works to prolong the recovery by stemming financial exuberance before it can occur to any great extent.
Seeing as nominal aggregate income/spending growth has been sluggish, the Fed would have to overlook this trend in favor of strongly signaling a policy rate increase soon. Wouldn't this actually risk contributing to the very financial instability that the Fed would be seeking to avoid? Falling aggregate income growth makes debt servicing more difficult leading to higher potential default risk throughout the economy. Surely existing debt contracts and bonds would look far less unsafe if NGDP was expanding at a pace of 5%+ compared to today's sub 3% rate. If this line of thinking is logical where the goal is financially stable economic activity, monetary and fiscal policy makers should be primarily focused on restoring a stronger pace in nominal aggregate income/spending.
After a massive global financial crisis, it's reasonable for policy makers to be concerned and watchful of financial excesses. However, at least right now the trend in total private US bond market debt outstanding (ex-US treasuries) and domestic credit market liability growth both do not suggest that domestic markets are overly exuberant. The fact that the 10-year US treasury yield hit a record low of 1.34% (not to mentioned the large chunk of global bonds trading with negative yields) just this year highlights how market participants are still seeking safety in part because they expect that global growth going forward will force central banks to remain on hold for much longer than once presumed. Couple this with the anemic rebound in private investment as well as nominal GDP in the post-GFC cycle and if anything firms don't appear to be overly optimistic about the future either.
It has been strongly argued that a banking system that is awash in interest paying Fed reserves is much safer than the one that preceded it. Perhaps a viable step forward would be for monetary and fiscal policy makers to coordinate in a way that would allow the treasury to issue bonds to fund higher NGDP growth while the Fed simultaneously expands its balance sheet and also pays higher IOERs. Where excessive private debt funded economic activity compromises financial stability whenever expectations sharply worsen/shift, increasing the stock of safe government securities held by the private sector and maintaining NGDP are the remedies.
4. Before the Fed can materially tighten, fiscal policy first needs to play a greater role.
Larry Summer among others have re-popularized the idea of secular stagnation in an environment where CBs are struggling with the zero lower bound while fiscal policy has remained off the table when it comes to forcefully pursuing a higher path for NGDP. Until the private sectors in the major developed economies are able and willing to boost what is currently a feeble level of private aggregate investment and demand, will major CBs be able to sustainably lift short-term policy rates without much more accommodative fiscal policy? In other words, aren't developed market CBs somewhat handicapped in their ability to increase policy rates without stronger NGDP growth first materializing? As monetary policy largely works by incentivizing the expansion of private credit, investment, and dissavings, shouldn't those that are concerned with preserving financial stability in the private sector be advocating for a greater use of fiscal policy? A better coordination between monetary and fiscal policy would enable the Fed to gradually increase interest rates as long as the treasury was expected to issue enough highly sought after treasury securities to fund and maintain aggregate spending growth (NGDP). At least temporarily, NGDP and employment growth would be less reliant on private investment and consumption spending funded by private sector dissaving (credit creation).
In, Central Banks Going Beyond Their Range, John Taylor writes (emphasis mine):
"The distortions created by policy include excessive asset price inflation, severe pressures on pension funds and a weakened banking system. The fundamental error derives from the exclusive role given to monetary policy.
This has led to loosening being pursued far beyond appropriate limits, the folly of negative interest rates being an extreme example. A balanced approach, with fiscal, regulatory, and tax reforms, would secure improved performance of the real economy and permit the return of a rational monetary policy.
Pursuing current policies is likely to result in serious instability as and when the monetary stance is adjusted and the distortions unwind. In addition to the negative impact on the recovery of the real economy there will be collateral damage to central bankers’ reputation.
They are attempting the exclusive management of the economy with tools not up to the job, and, in consequence, central banks are pushed into being multipurpose institutions beyond their range of effective operation."
5. Weak productivity growth may be symptomatic of deficient aggregate demand
How much of the present productivity slowdown debate has to do with demand side factors considering the downtrend in US and global NGDP and RGDP growth and the ongoing decline in developed market sovereign nominal rates and inflation after each recession since the 1980s? Consider,
"Falling interest rates are meant to reduce the cost of borrowing. But investment and production decisions taken by firms are influenced by the expectations that entrepreneurs form about future revenue, in addition to cost streams, which allow them to make guesses about what their profits might be.
Firms are continually making guesses about the future in terms of what the overall state of demand for their products will be, what they are likely to receive by way of revenue if their sales match these expectations, and what it will cost them to produce the output necessary to meet this demand.
Investment decisions will thus depend on whether the productive asset being purchased delivers a positive return above the cost.
It is clear how the imposition of fiscal austerity will undermine investment plans irrespective of what is happening to the cost of finance.
In an environment where firms continue to expect prolonged economic weakness that has spread globally, is it any wonder that real domestic output is still below potential? This becomes problematic when employment growth begins to outpace nominal and real GDP. Supply side factors obviously also play an important role. However those forces shouldn't be allowed to easily dismiss the possibility that deficient aggregate demand may be causing productivity to appear suppressed due to the sluggishness in the numerator (output) relative to employment. The more dire scenario being that a continuous demand shortfall risks contributing to a long term slowdown in potential output (due to human capital deterioration as skills are lost, deficient capital and infrastructure investment, a lack of exploratory R&D etc). If there is any possibility of the latter, policymakers must respond at least until private investment is once again in a position to utilize the slack in the economy. Otherwise long-term living standards are in jeopardy.Firms will not invest in new productive capacity if they can satisfy current sales with their existing capacity and expect sales to be flat or falling in the period ahead."
6. The global political situation remains volatile and particularly unpredictable.
Market participants began to expect a much more gradual path for UK and DM interest rate policy following Brexit. In the UK, the political support for tight fiscal policy has also waned. As we know, these market expectations in part caused the pound to depreciate. At least in the short-term, the perception seems to be that this has allowed the UK economy post-Brexit to remain resilient (even though in the intermediate/long-term falling real rates and currency depreciation are symptoms of weakening RGDP growth). Before the vote, according to the media and pro-remain supporters this was not supposed to happen (a failure to factor in a short-term reprieve due to the expectations of a monetary and fiscal policy offset).
Market participants began to expect a much more gradual path for UK and DM interest rate policy following Brexit. In the UK, the political support for tight fiscal policy has also waned. As we know, these market expectations in part caused the pound to depreciate. At least in the short-term, the perception seems to be that this has allowed the UK economy post-Brexit to remain resilient (even though in the intermediate/long-term falling real rates and currency depreciation are symptoms of weakening RGDP growth). Before the vote, according to the media and pro-remain supporters this was not supposed to happen (a failure to factor in a short-term reprieve due to the expectations of a monetary and fiscal policy offset).
Rightly or wrongly, will this lack of economic and financial volatility post-Brexit provide ammunition to Euroskeptic political parties who seek to emulate the UK's decision given the temporarily muted consequences? On the other hand, will EZ policymakers eventually be forced to adopt much less fiscal restraint if not doing so increases the risk of rising support for parties that want to defect from the EZ? For all its efforts, the ECB has not been able to adequately deal with sluggish nominal and RGDP growth seeing as the EZ private sector is still unable or unwilling to increase their pace of investment and consumption spending on aggregate enough to materially close the EZ's output gap. So what is more likely, a rise in EZ defection risk following Brexit or a greater application of fiscal policy in the EZ? How will these dynamics in Europe affect and be influenced by the stance of US monetary policy?
7. The transmission of US monetary policy to foreign economies via the FX markets is strong.
At what point do market participants purchase negative yielding bonds (say in the EZ) instead of higher yield treasuries because they expect the former's currency to eventually appreciate relative to the dollar? Given the yen's strength since 2015 vs the dollar, has this condition already happened in Japan? What does this say about the limits of monetary policy especially in countries that run persistent current account surpluses?
With that said, the dollar's role is the dominant factor in the FX markets as expectations pertaining to the path of Fed policy and by extension real interest rate differentials both influence proceedings globally. As markets begin to strongly anticipate at least one rate hike in the final months of 2016, it may be worth revisiting the price action in the US treasury bond and FX markets that occurred prior to the December 2015 hike. By October 2015, treasury bonds began to sell off violently as the dollar started to surge against a broad range of currencies. Although the dollar and the treasury rate rise eventually did reverse while risk assets bounced back for much of 2016 (see February, May, May market commentaries), as mentioned too many times already (apologies) the troubling deceleration in NGDP and RGDP has not.
Conclusion
After taking into account the aggregate macro data, the Fed's dual mandate, financial stability concerns, the stance of fiscal policy, the productivity puzzle, the potential fall out from Brexit, and how Fed policy influences foreign economies, signaling another rate increase before the end of 2016 seems precarious and imprudent. Unless nominal GDP stops decelerating, a rate move before that occurs may be labeled as a policy mistake in hindsight. More so than it already has, the Fed would be preemptively tightened monetary policy without first enabling a stronger expansion to first take hold. Although central banks should not be expected to carry the recovery single-handedly, it's still obviously important that they avoid needless policy errors particularly when their tools to stem an overheating economy are tried and tested compared to those that they would be forced to employ when repeatedly confronted with the zero lower bound.
To quote Fed Governor Brainard and Larry Summers once more (emphasis mine),
Brainard:
"The experiences of these economies (Japan and Europe) highlight the risk of becoming trapped in a low-growth, low-inflation, low-inflation-expectations environment and suggest that policy should be oriented toward minimizing the risk of the U.S. economy slipping into such a situation."Larry Summers:
"On balance, I think the Fed’s complacency about its current toolbox is unwarranted. If I am wrong in either exaggerating the risks of recession or understating the efficacy of policy, the costs of taking out insurance against a recession that cannot be met with monetary policy are relatively low. If my fears are justified, the costs of complacency could be very high. The right policy in the near term should be tilting as hard as possible against recession"
I couldn't agree more here. So I ask has the case for an increase in the fed-funds rate really strengthened in recent months?
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