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2017-12-07Macro `n Cheese

Party animals with a deaf-ear

Next week’s FOMC-meeting will prove interesting indeed. “Mysteriously” low inflation and continued monetary policy contraction do not mix. Roger believes this means the FED will soon pause. What do you think?

Long-time (1951-1970) Governor of the US Federal Reserve, William McChesney Martin, once remarked that the art of central banking is “to take away the punch bowl just as the party gets going”.

Nowadays, you can be excused for thinking the FED is taking away the punch bowl well before the guest of honor has even arrived. Both the FED and market commentators are actively discussing the coincidence of continued hikes, low (too low) inflation, and a yield curve creeping closer and closer to a feared inversion (a recession signal). No matter your predisposition, such developments beg the question, is continued monetary policy contraction warranted or not?

Business as usual?

Admittedly, I am a bit late to this particular party. But in my opinion, there are a few variations on this theme that I feel we need to distinguish:

As I have highlighted in previous posts, the FED is following a well-trodden path, allowing the Phillips relationship to decide the general direction of monetary policy1. This does not, in any way, imply that the FED is making a mistake. Maybe the interaction between labor market and inflation never was as stable and exploitable as we hoped, or made it out to be. Perhaps inflation is indeed around the corner, but it is taking a tad longer than expected.

1Former Minneapolis FED-president Narayana Kocherlakota has an interesting take on an L-shaped Phillips curve in a recent NBER-paper: Macrobond Document
Chart 1: Short run Phillips curves

If the FED had stopped there, I think the critique that is being directed toward it would have been more…productive, for want of a better word. However, both Yellen and the FED-Governor to be (Jerome Powell), as well as other FED luminaries, insist on calling the continuously too low inflation outcomes a “mystery”. If it is indeed a mystery, if the FED does not understand the low inflation outcomes, then why are they sticking to a plan of both interest rate hikes and scaling down the balance sheet?

Put up or shut up?

Market Watch writer Caroline Baum frames it this way: The FED should either put up, and make financial conditions more expansionary again, or it should shut up and let the transitory factors (of five years and counting) slowly exit the inflation calculations. That would demonstrate confidence in the Federal Reserve’s monetary policy framework and in the fine work (e.g., here, here and here) that some of their employees have produced over the past few months.

However, the current discussion reminds me of a meeting at the Riksbank a few years ago, when talking to a deputy Governor and celebrated monetary economist about the continued Riksbank hikes (on which I and a few others disagreed). He made an analogy of when he bicycled to work (remember, this is Sweden we are talking about) in the mornings. If his bike helmet would suddenly slip over his eyes, he said, it would be wise not to swerve from side to side, but rather to try and continue on a straight line...

– Wouldn’t it be even better to just stop, was my obvious riposte.

This seems, to me, equally applicable to the current FED predicament. If they are genuinely uncertain about what is holding back inflation in the face of low unemployment, would it not make sense to, at the very least, stop hiking?

Tensions within the FED

Basically, the FED is saying that inflation is not increasing the way they expected. In response to the low inflation, the FED then hikes interest rates and start to scale back the balance sheet; measures we know will subdue inflation further! To detract from this impression of seemingly counter-intuitive monetary policy decisions, a pause would be sorely needed. However, as we have little (any?) evidence of a more pronounced weakening of the economic outlook, there should be no need to make a complete volte-face and start expanding monetary policy2.

2Admittedly, given expectations, a pause should have expansionary effects via lower market interest rates and a weaker USD.

More importantly, a pause would not only shield the FED from making hard to explain policy decisions, but also temper increasing tensions within the FED: “Many participants” observed some likelihood of inflation remaining below target at the latest FOMC-meeting, and “a number of these participants” advocated a more gradual removal of stimuli. The criticism does not end there; in a retort to many years of sub-par inflation, we have recently heard former FED chairman Ben Bernanke and current Chicago FED President Charlie Evans advocating variations of price level targeting regimes (where policy must explicitly make up for previous undershooting of inflation).

How to kill an expansion

From outsiders, the criticism rests more often on a somber outlook for demand, e.g., the way monetary policy normalization is expected to take its toll on the economy. Indeed, one often cited indicator of economic developments, the yield curve spread, has been steadily approaching the feared point of inversion, which has been an accurate signal for the last seven recessions3.

3Nota Bene, the implied probability of recession from this indicator is at the time of writing only around 10%. Also, the yield curve spread currently implies around 1½% AR GDP-growth. Macrobond Document Note: here we have plotted the yield curve against Real Final Sales to Domestic Purchasers, which both former CEA chair Jason Furman and at least a couple of FED economists seem to hold in high esteem.
Chart 2: Heading for a fall?

Discussants, nonetheless, point to the simple fact that monetary policy per se, primarily abundant liquidity in both the US and elsewhere, has been driving the term premium down4. But this time is different, the argument goes.

None the less, we can perhaps make a crude estimate of how this excess liquidity has affected yields on different maturities. Using a recent Fed note on the effects5 on the term premium of the FED’s purchases and assuming that effects on other maturities follow the normal term structure we can “distribute” the term premia effect from the FED’s purchases over the entire yield curve. In the table below, I have distributed the effect according to the second eigenvector of a simple PCA6 on the US Treasury yield curve.

4On the Federal Reserve Bank of New York page for the yield curve indicator other structural changes to the term premia are also discussed.
5Most academic studies (see e.g. Bonis et al, 2017) point to a term premia effect (on 10yrs T-Bonds) of up to and around 100bp from the different large-scale asset purchase programs (incl maturity extension prog).
6The second eigenvector in a PCA is often said to represent the slope of the yield curve. For more on how to use PCA to model the term structure see, e.g., here.

Maturity Eigenvector, C2
(Eigenvalue: 0.0033)
Distributed Term Premia effect (in bp)
1 yr -0.736 -2.3
2 yrs -0.352 30.4
3 yrs -0.125 49.7
4 yrs 0.098 68.6
5 yrs 0.125 70.9
6 yrs 0.238 80.5
7 yrs 0.256 82.0
8 yrs 0.296 85.4
10 yrs 0.291 85.0
Table 1: Distributing the term premia effect of the FED’s Large Scale Asset Purchases (LSAP)

Adjusting the yield curve spread accordingly increases the distance to inversion to around 200bps, which pushes this particular recession indicator above (i.e. better than) its historical average. Of course, this does not imply that FED hiking and paring its balance sheet cannot eventually push financial conditions and the economy into recession. It merely suggests that, at present, the yield curve spread is a comforting distance from levels that historically have implied an increased risk of recession on a 12-month horizon.

That said, by now, this expansion is already the third longest on record and one-year hence it will officially be the longest expansion on record (albeit meagre in terms of income and employment growth).

Macrobond Document Note: the dates are end-dates of each expansion. The size of the bubbles relates to total payroll growth (scaled by working age population) in each expansion and the position on the Y-axis shows the total real GDP/capita growth in each expansion
Chart 3: Growing old, without the benefits

Time for a FED winter holiday?

It is said that expansions rarely die of old age. However, it is quite not uncommon for the FED to kill them off with excessive rate hikes or similar. Perhaps the longevity of the expansion, together with the FED’s deaf-ear approach to inflation developments will do the trick?

If the FED continues to hike while inflation lingers at “mysteriously” low rates, it will eventually succeed in killing off this old and fragile expansion as well. Indeed, with continued low-flation I believe the FED will put their feet down and pause its hiking (with balance sheet reduction to continue). I would not be surprised if that’s also on Yellen’s wish-list at next week’s FOMC-meeting. Luckily for her (and luckily form me) it will soon be Christmas.

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