The Implicit Question
“Are financial conditions expansionary?” – This is one of the fundamental questions that underlie almost all analyses, forecasts, presentations, discussions, decisions, and investments in financial markets. You think interest rates are low, so you guess they will go up. You think a currency is weak so the car company with sales abroad should do well. You think the term premia is high so banks should be profitable, etc. – If financial conditions are expansionary, the economy should perform well, at least within a not too long timeframe.
But ‘expansionary’ implies there is a benchmark, a base case. The currency is weak, but relative to what? Interest rates are low, but relative to what? – All too often, if anyone dare ask, the reply to that question is an unconvincing and utterly unsatisfying: “To what it should be”.
What should it be then? – Well that’s just the question for today’s blog. If we start off by looking at some academic efforts to pinpoint what, e.g., the interest rate should be, it is obvious that “it depends” would be a better answer. It depends on time, among other things, because over time, the natural rate (i.e., what rates “should be”) seems to have trended downwards.
Macrobond moment: Not only do Macrobond carry the different r* estimates from New York Fed and the Wu-Xia (Atlanta FED) estimates of shadow policy rates (estimated policy rates trying to take into consideration UMP-measures), but also an intriguing set of shadow rates from Krippner (Reserve Bank of New Zealand) to compare with.
Admittedly, this phenomena of declining long term / average / equilibrium / natural interest rates has been a keen subject for many years now, but it is only quite recently that some kind of academic and policy maker consensus on “lower for longer” or, even, “lower forever” has been built. The
arguments used are many, including demographics, savings glut, decreased risk premia, etc. In any case, this newfound agreement underpins an increased call for fiscal policy to take over some of the fiscal stabilization responsibilities and helps explain the mounting fears of central banks being – or becoming – stuck below the effective lower bound.
Stimuli, What Stimuli?
This is all well and good of course, but take a look at the chart below where I have added the Wu-Xia Shadow Rate to the chart above, which apart from policy rates also include unconventional monetary policy measures (UMP) to construct a more comprehensive measure of monetary policy. To me, alas, it seems there is still something wrong with the notion of what interest rates “should be”.
 Current estimated levels of natural interest rates fit well to policy makers long term projections (here).
For the Euro Area, it is blatantly obvious that monetary policy has only become more and more accommodative, as the gap between the (Wu-Xia shadow) policy rate and the (long term) natural interest rate has never been bigger (implying the most stimulative policy stance ever), without producing much of an economic expansion.
But, even for the US, something seems wrong. Undeniably, the FFR did touch the level of the natural rate estimates for a while (last winter/ this spring), lending some support to the idea that it was “perhaps the greatest economy we’ve had in the history of our country”, to borrow a phrase from the ever-so-eloquent Commander in Chief. Unfortunately, that benign situation does not seem to have lasted very long as rates have gradually come down since, indicating that the historically low estimates of the natural rate was more of a ceiling than an average. In this context it is also worth noting that the r*-estimates above are still very much in line with official views (where those exists) on equilibrium rates.
Moving over, instead, to a markets perspective (and focusing on the US), I hope we can agree that one of the ‘best’ measures on neutral rates is the 5 years’ real rate in 5 years’ time (5y5y). Comparing that to how markets weigh the policy outlook over the immediate future should, thus, provide us with an estimate of how financial markets interpret (and transmit) the monetary policy stance.
Interestingly, as the FED indicated a more pronounced hiking cycle during winter 2016/17 policy rates increased relative to markets perception of the neutral rate which is a clear indication that the hikes were indeed perceived as a tightening of the monetary policy stance. However, as the FED began to contemplate reversing course and lowering rates, markets were already shifting down their long-run expectations, suggesting that the monetary policy stance is – on balance – unchanged. In other words, the FED interest rate cuts thus far have only managed to keep pace with financial markets’ deteriorating views on what rates “should be”, implying no real loosening of monetary policy.
Macrobond moment: There are a number of ways to highlight events, and developments in Macrobond. Here I have used a recent improvement to the ‘observation labels’ feature to emphasize different phases.
– In short, if the FED is really looking to offer support to the economy, now is neither the time nor the place for an extended pause. I assume markets will make that message very clear to the FED in the coming months.