A Major Rethink is Underway at the Fed

United States monetary policymakers made their bones during the 1970s stagflation crisis. Figure 1 displays the macroeconomic vitals and the policy rate from the mid-1960s to the mid-1990s.


Figure 1. Unemployment, core inflation, output gap and the policy rate from the mid-1960s to the mid-1990s.

The stagflation crisis taught central bankers that inflation can be very costly to tame; that inflation expectations play a dominant role in the inflation process and are even harder to tame; that elected officials with an eye on the next election have an inflationary bias so that the Fed had to be sufficiently independent of politics to deliver the bitter medicine. Most of all, they learned that the Fed had to stay one step ahead of inflation. Specifically, they learned that they had to tighten policy in anticipation of an acceleration in inflation. And that they could rely on the Phillips curve to anticipate inflation. That is, when domestic measures of slack (such as the unemployment rate or the output gap) showed that the economy was overheating, they could reliably expect inflation to pick up.

Inflation expectations are said to be anchored if temporary shocks don’t change long-run expectations; that is, they are relatively insensitive to incoming data. Consistent with its price stability mandate, the Fed wants the public’s inflation expectations to be anchored near the target rate of inflation. Although the Fed did not officially adopt a numerical target until 2012 when it chose 2 percent, it was widely understood to be within that ballpark under Greenspan. Nevertheless, it literally took decades. By the end of the 20th century, they had finally managed to anchor inflation expectations close to the target.


Figure 2. Expected inflation in the United States.

But just as central bankers began to congratulate themselves for finally having anchored the public’s inflation expectations, the inflation process mutated. The Phillips curve, on which the Fed (and all macroeconomic models) relied on to forecast inflation, weakened in the 1990s and broke down after 2000. Figure 3 displays the breakdown.


Figure 3. The Phillips curve weakened in the 1990s and broke down in the 2000s.

As a result of the second unbundling and the further integration of global product markets, global slack replaced domestic slack as the strongest predictor of changes in inflation. In other words, the inflation process became globalized. But Fed policymakers continue to rely on measures of domestic slack to anticipate inflation even as they concede that the relationship has weakened.

Since domestic measures of slack have vanished, the Fed expects inflation to be around the corner. It has hiked four times (by 25 basis points each time) in the past two years (12’15, 12’16, 3’17, 6’17). Bond markets are assigning an 80 percent probability to another 25 basis point hike this December. Meanwhile, the Fed has blamed transitory factors (such as one-off mobile price plan changes) for the failure of inflation to pick up.


Figure 4. US unemployment, output gap, core inflation and the policy rate.

Things are now coming to a head. Core inflation slowed to just 1.3 per cent year-on-year in August despite further tightening in the labor market and the vanishing of the output gap. Minutes of the FOMC’s September meeting show policymakers troubled by the failure of inflation to appear as anticipated. From the minutes:

Many participants expressed concern that the low inflation readings this year might reflect not only transitory factors, but also the influence of developments that could prove more persistent, and it was noted that some patience in removing policy accommodation while assessing trends in inflation was warranted.

Meanwhile, Daniel Tarullo, who left the Fed’s Board of Governors this year, confessed that the Fed is driving blind. “The substantive point,” he said, “is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking.” The Fed should therefore not rely on the Phillips curve, but instead pay more attention to “observables”. That’s just a fancy way of saying that the Fed should wait to see the whites of inflation’s eyes before tightening further.

So the doves are gaining the upper hand at the FOMC. But even more significant developments are underway.

Former Fed Chair Ben Bernanke, the intellectual father of extraordinary monetary policy, has proposed a new monetary policy framework that makes the recent hikes look even more suboptimal.

A central bank could target the rate of inflation or the price level. When the monetary authority targets inflation, it responds to cyclical departures from the target rate by leaning against the departure in order to push inflation back to target. It does not bother “making up” for lost inflation. With price level targeting on the other hand, the monetary authority obeys the “makeup principle”. If inflation is too low, policy remains accommodative even after the target is hit; letting it overshoot to make up for lost inflation. Under price level targeting, average inflation is likely to be close to the target over the medium term (ie, over the cycle). But there are issues with price level targeting.

Price level targeting becomes problematic when there is a negative productivity shock that pushes up inflation. For then the monetary authority is committed (as it must be to maintain credibility) to punish the economy well after inflation is under control. In the extreme, periods of high inflation would call for prolonged lowflation or even outright deflation to get back to the target price level. That’s close to being unacceptable.

Bernanke’s proposal instead requires the monetary authority to practice inflation targeting under normal conditions but shift to price level targeting once the economy hits the zero lower-bound. In effect, the monetary authority would commit to “lower for longer” for much longer. It would run the economy too hot for as long as it takes for the actual price level to close the gap with the target price level. It thus solves the problem of policy asymmetry at the zero lower-bound by essentially borrowing policy room from the future.


Figure 5. Price level, inflation and the policy rate.

This is the most accommodative monetary policy framework that has ever been proposed. It goes well beyond waiting for the whites of inflation’s eye to begin tightening. Figure 5 shows the price level, inflation rate and the policy rate since we hit the zero lower-bound. Since inflation has run persistently below target for essentially the entire period, the actual price level has continued to diverge from the proposal target level (which mechanically increases at the rate of 2 percent per annum). Under his proposal, not only would the Fed not have hiked until today, it would commit to not hiking for many, many years to come. Given that system-wide overcapacity is likely to persist for a long time and assuming that global slack continues to drive US inflation, the nominal policy rate under his proposal would remain stuck at the zero lower-bound through to 2030!!

This amounts to a thinly-veiled but nonetheless extraordinarily powerful critique of Fed policy. Bernanke is in effect saying that the Fed should’ve never lifted off in anticipation of inflation. Instead, it should’ve promised to not lift-off even after observing above target inflation for a considerable amount of time.

Lael Brainard, perhaps the sharpest knife in the Fed drawer and not coincidently the Policy Tensor’s favorite central banker, favourably reviewed Bernanke’s proposal. Her remarks are worth reading in full. Both Bernanke and Brainard made their remarks at the Peterson Institute which has conveniently put the videos online. On that site, you can also find presentations by Summers and Blanchard of their joint paper on stabilization policy under secular stagnation—no doubt an important contribution.

So a major rethink is well underway among central bankers. And not a moment too soon. Reviewing these developments together with the markets makes it clear that the bond market is too confident of a December hike. That should get priced out soon.



A Fool’s Game

The Dow Jones Industrial Average surpassed 17,000 for the first time in its history last week. The S&P 500 is at an all time high as well. Only the Nasdaq hasn’t surpassed its tech-bubble peak. And its not just the stock market—real estate, high-yield bonds, emerging markets, government debt, fine art—you name an asset and I promise you it’s booming. The latest craze is frontier debt. That is, bonds of dicey governments such as those in sub-Saharan Africa. Credit spreads—the differential in borrowing costs faced by investment-grade and lower-rated firms—are at an all-time low. Overall market volatility has almost never been lower. It looks like the good times are here. Except, they most decidedly are not.

The economic recovery is, in fact, tepid. The US economy is expected to grow a mere 2.1 per cent this year. In the first quarter, it actually shrank by 2.9 per cent. Yes, the unemployment rate has fallen to 6.1 per cent, exactly where it was on the eve of the financial crisis in December 2007. But, as of June 2014, 2.7 per cent of adults who wanted a job were not actively looking for work. Another 3 per cent of the population in working part-time because they can’t find full-time work. Counting the underemployed and the discouraged, the labor market shortfall is 15 per cent. Not that the pre-recession era was all that swell. In December 2007, this shortfall was 12 per cent. 

At $2.1 trillion, corporate profits are higher than ever; accounting for an eighth of US GDP, tying the previous record that was set by the 1942 war economy. The effective corporate tax rate back then was 55 per cent, compared to 20 per cent now. No wonder corporate profits after tax accounted for a tenth of GDP; a new record. Meanwhile, the share of wages and salaries in 2013 was 42.5 per cent; another record low. One could assume that with the going so good for the masters, at least the sky-high equity valuations would be justified. One would be wrong. The Shiller P/E ratio, at 26, is back to pre-recession levels. The forward price/earnings ratio is also back to the pre-crisis bubble years. Amazon, the darling of the stock market, is trading at more than five hundred times its earning per share. The risk premium demanded by investors to compensate them for holding riskier assets is back right down to levels last seen in 2004-2006. Amidst a weak economic recovery, we are witnessing nothing short of a financial boom.

This isn’t quite Tulip mania. Investors—at least the clear-eyed ones—know that assets are overpriced. Yet, they are in no hurry to sell. This is because the financial boom is a foster child of the United States Federal Reserve. And as every child knows, you’d be a fool to fight the Fed. The markets are simply dancing to the Fed’s tune. 

The Fed has followed an extraordinarily accommodative monetary policy for nearly six years. The policy rate has been zero since December 2008. Soon after hitting the zero lower bound (ZLB), the Fed embarked on non-standard measures proposed by Ben Bernanke in 2004. This policy has three components: (1) Forward Guidance: declaration by the Federal Open Market Committee (FOMC) to influence the expectations of market participants; (2) Expanding the Fed’s balance sheet beyond what is required to maintain rates at the ZLB: what’s called Quantitative Easing (QE); and (3) Outright Asset Purchases: intervention in markets of distressed debt and toxic assets to prop up prices in order to prevent banking crises. The Fed’s balance sheet has grown from a few hundred billion dollars to $4.3 trillion. It is now in the process of “tapering”—that is, slowing down the expansion of its balance sheet, which will continue to grow through this fall. Fed officials are mulling what to do with that giant pile in the long run. They reckon they’ll have to keep it. The highly-unusual intervention in various distressed assets, what purists would call “price administration,” has stabilized financial markets. Forward Guidance has been unexpectedly effective. Bernanke’s “taper tantrum” last year prompted a large-scale sell-off of emerging market funds and led to a sharp spike in market volatility generally. The Fed’s clarification calmed the markets and the market response to the actual taper has been quite tame.

BIS figures

Such extraordinary intervention has pushed down the entire yield curve on government bonds, precisely as the Fed intended. Investors’ search of yield has pushed up prices of assets across the board, thereby depressing yields on all assets. The decline of volatility and inflation expectations have increased the risk appetite of investors. The elevated risk appetite of investors has in turn buoyed up demand for lower-rated debt. US firms have increasingly tapped capital markets to exploit record low yields, at a time when many banks have been restricting credit. Gross issuance in the high-yield bond market alone soared to $90 billion per quarter in 2013 from a pre-crisis quarterly average of $30 billion. Since cheap credit has enabled troubled firms to refinance easily, corporate default rates have declined. The depressed default rates have in turn justified tighter credit spreads. Firms are using cheap credit to pay higher dividends, buy back shares and engage in mergers and acquisitions. This has allowed very many troubled firms to look quite dandy. Remarkably, despite the vanishing costs of finance, nonresidential fixed investment by nonfinancial firms is flat; perhaps in light of the economy’s actual prospects. 

It’s clear that the Fed’s bubble economics is causing a major misallocation of capital resources. The notion of price discovery has disappeared from asset and credit markets as prices increasing diverge from fundamentals. Perhaps more importantly, the risk of a major financial bust as the Fed tries to implement an exit from its extraordinarily accommodative monetary policy is getting more and more serious. Based on these considerations, the Bank of International Settlements (BIS) issued a stern warning against delaying policy normalization. Fed Chair Janet Yellen has dismissed such concerns. Krugman is still making fun of bond market vigilantes. The IMF considers the baseline scenario to be a smooth exit. Right, we’ll see about that.

Basically, everyone caught on the floor when the music stops playing is going to pay dearly. This is why smart money has moved into a conservative capital preservation strategy. For instance, the cash component of JP Morgan’s fixed income fund, the world’s largest, is now no less than three-fifths. 

The Fed has painted itself into a corner. There is no smooth exit now. The Fed simply cannot normalize policy without dislocating world markets. And the longer it takes to reverse policy, the worse the dislocation.