Wednesday, December 14, 2016

The Fed didn't tighten today

The Fed increased its target short-term interest rate today to 0.75%, but that doesn't represent a tightening of monetary policy. It would be more correct to say that today monetary policy became slightly less accommodative. Neither the market nor the economy has anything to fear from today's Fed action. Financial markets today enjoy plentiful liquidity conditions, and confidence in general in rising.  Interest rates have adjusted upwards slightly to reflect this. Remember: higher interest rates don't threaten growth; interest rates are higher because growth expectations are somewhat stronger. This is all good news. Today's modest decline in equity prices is more a buying opportunity than a warning sign.

The chart above compares the current real short-term rate (red) with the market's expectation for what the average real short-term rate will be over the next 5 years (blue). The current real short-term rate is about -1%, and that rate is expected to average about zero over the next 5 years. There is no way this represents a tightening of monetary policy for the foreseeable future. And since the real yield curve is still positively sloped (i.e., the blue line is higher than the red line), that is yet another indication that monetary policy is not tight, nor is it even beginning to get tight. The time to worry is when the red line approaches and exceeds the blue line (as happened prior to the past two recessions), because that is the market's way of saying the Fed is tight enough to threaten growth.

The chart above shows that the prices of gold and 5-yr TIPS continue to track each other (using the inverse of the real yield on TIPS as a proxy for their price). This is significant, because it says that the market is willing to pay less for the protection of TIPS and gold, and that in turn is equivalent to saying that the market is regaining confidence in the future. Gold is still quite expensive (my calculations say that the long-term average price of gold in today's dollars is somewhere in the neighborhood of $500-600 per ounce), and real yields are still very low, so it's still the case that the market is on the defensive, and risk aversion is still evident.

Swap spreads are almost exactly at a level which is "normal." That means that liquidity conditions are very healthy, and it further suggests that the outlook for growth is also healthy. No one is being starved of liquidity as a result of the Fed's "tightening" of monetary policy. In the past, prior to IOER, the Fed tightened by reducing the availability of bank reserves, which tends to shrink the amount of money in the financial system. But that is not the case today. All the Fed has done is to change the appeal of holding cash equivalents—by making them somewhat more attractive on the margin. That is a prudent move, because the recent rise in the equity market tells us that the market is becoming more optimistic on the margin about the future, and more optimism would imply less demand for cash equivalents. The Fed needs to respond to rising optimism by making bank reserves more attractive; otherwise banks might be tempted to lend too much, and that could give us higher-than-expected inflation.

As the chart above shows, credit spreads are still relatively low. That's another way of saying that the Fed's move today presents no threat to economic growth. Markets are comfortable with the Fed's move, and generally agree with the Fed's assessment that the economic outlook has improved somewhat and that higher real rates are justified.


Thinking Hard said...

Scott - What's your thoughts on the contracting monetary base at currently 9.6% yoy? What are your thoughts on the Fed's utilization of the ON RRP in order to set a floor for the FFR with a max utilization rate of approx. $2T? The Fed altered the ON RRP methodology some today ( but I still believe they will have a difficult time raising rates too much further. The monetary base contraction coupled with a theoretical higher ON RRP utilization rate will place headwind pressure on further rate hikes.

The ON RRP seems like the tool to watch, as SOMA is limited and the utilization rate climbs.

Scott Grannis said...

The monetary base is shrinking on the margin, but it is still huge. I don't see this as a problem now, but more shrinkage might be called for in the future. I also don't see a problem in using RRP to set a floor on rates. We'll have to watch and see how things develop, of course, but for now it looks like the market and the Fed are in sync with what needs to be done and there is no reason to think the Fed can't raise rates further. It still seems clear to me that the Fed is a follower and not a leader in this dance.

AUGUST said...

Yellen spouted the outgoing party line about the rosy economic conditions necessitating an increase in short rates. She put a positive spin on low labor participation rates, anemic job growth and historic low growth of our economy. None of these conditions required an increase in the short rate as you indicate in your comment that rates are still below zero. Hopefully, we can get back to truthfulness in our governments affairs.

Benjamin Cole said...

Suffice it to say a person attracted to a career in central banking is not an entreprenuer, real estate developer or even ordinary business guy risking capital.

I think the US has been giving up 1% or 2% real growth every year on the central bank altar of "fighting inflation."

A quarter-point hike and the mysterious reverse repo program probably will not derail 2% real growth next year.

But what is the point?

The good news is that soon Trump will try to edge out Yellen, on the grounds that she is "not good enough looking."

Benjamin Cole said...

Suffice it to say a person attracted to a career in central banking is not an entreprenuer, real estate developer or even ordinary business guy risking capital.

I think the US has been giving up 1% or 2% real growth every year on the central bank altar of "fighting inflation."

A quarter-point hike and the mysterious reverse repo program probably will not derail 2% real growth next year.

But what is the point?

The good news is that soon Trump will try to edge out Yellen, on the grounds that she is "not good enough looking."

WealthMony said...

Scott, I agree with your "less accommodating" characterization rather than tightening. But I'm unsure about how you describe the relationship between higher interest rates and economic growth. Didn't the Fed use higher rates to push the economy into a deep recession in the early 1980s? Didn't higher rates help bring on the market collapse of 2000-2002, and again in 2008? I know it was not the initial hike or even the second one, but a steady increase in rates will eventually crowd out equity returns and crush a growing economy. I am an investor and I read a great deal, but I fear we all know too little about credit markets and economic variables. There are just too many moving parts.

That said, I want to express my appreciation to you for your ongoing insight and analysis. I welcome Donald Trump's goal of lower corporate tax rates, less regulation and modernization of infrastructure, as well as his efforts to smother government waste.

I wish him well, but if labor is the heaviest input cost in manufacturing, and technological innovation is the biggest contributor to manufacturing job losses, I don't know if we will see a manufacturing renaissance. I hope we do. The town where my father lived, Milledgeville, Georgia, lost hundreds or thousands of jobs because textile plants either closed or moved to Asia, while other industries moved offshore. Only the growth of a state university has kept the town going. I would love to see those jobs return.

I have followed with great interest your tracking of the post-2009 U.S. economy at 2.1% versus the long term trend of 3.1% real growth, and the $3 Trillion shortfall. Do you think this means there is $3 Trillion of pent-up demand in the pipeline that we may see unleashed over the next 3-4 years?

One final question, if you please. What do demographic studies say about economic growth over the next 10 years? I thought Harry Dent did some very interesting and helpful demographic analysis until he became radicalized and found it too profitable to peddle fear, doom and gloom. If only I could find a replacement because I don't see much attention given to the demographic component.

Scott Grannis said...

WealthMony: As I think my first chart shows, it takes very high real interest rates to kill the economy. Undoubtedly we will return to that point once again, but it's still way out on the horizon. High real rates (>3-4%) and a flat or inverted yield curve have preceded every recession for the past 50 years or so. But we're not even close to seeing that yet.

I don't know if we'll have a manufacturing renaissance, or if that is even desirable. I would never attempt industrial policy. If Trump does the right things (lower taxes, less regulation, strong dollar) then jobs will come, but we'll just have to wait and see where they come from.

The $3 trillion "gap" is a measure of the upside potential of the economy, not pent-up demand. There is an army (upwards of 10 million) of workers that have "dropped out" of the workforce that could return if businesses decide to invest and expand.

I'm not a demographic expert, but I do believe that if animal spirits return and investment increases under the right set of policies, then we will see economic growth swamp any effects of demographics. Demographics will be a second or third-order variable.

John A said...


Personally I think Scott underestimates the power of demographics, but time will tell. Anyway, here are two commentators I follow who usually have interesting demographic insights. First is Matt Busigin:
Second is the like-minded Conor Sen:

Al said...

Nice summary scott.

WealthMony said...

Scott, I am very appreciative to you for your reply and always for your thoughtful, insightful, informed and right-on analysis. You've contributed much to the economic education of your readers. I respect your confession regarding demographics. John A, I also wish to thank you for your references and I can assure you I will check them out.

McKibbinUSA said...

I agree with Scott that gold should be selling at closer to $500-600 per oz.

Unknown said...

Mr. Grannis, what is your source for the swap spread data? I used to get it from the St Louis Fed site but they stopped publishing the series as of the end of October. Is there another place where the two-year swap rate is published?

Justin said...

Shouldn't gold's price permanently reflect the "carry." A bond investor or currency investor receives interest. If a gold was only a function of real yields a price from 30 years ago vs now wouldn't incorporate this. At a minimum it should retain whatever inflation has passed from point A to point B. I agree (I mean it's pretty obvious from your charts and recent experience) bond yields are a driver, but using it as a way to predict price seems flawed by this way. History also speaks to this notion - paper decreases in value (purchasing power) while gold tends to buy the same.

Scott Grannis said...

Gold is a unique asset. We know for certain a few things about gold: It pays no interest, its price in real and nominal terms can fluctuate dramatically over time, it is universally regarded as precious, and the production of new gold tends to be about 3% of the outstanding stock of gold (so gold's price is not heavily influenced by new production). It tends to rise about the same as the price level, but only over very long periods (decades). It can be a very good or very poor investment. Since 2001, gold has risen from $250/oz. to as high as $1900/oz, and it is now worth about $1140/oz.

In real terms (in today's dollars), and over the last century, gold has ranged between about $200/oz. and $1900/oz. It has averaged about $500-600/oz.

I have studied gold for many years and have never found a reliable connection between the gold price and inflation and/or monetary policy. It is unpredictable, and highly variable. I think the gold price gives us some information about the mood of the market (eg., high prices tend to correlate to periods of great uncertainty), but few have the ability to predict how gold will behave. I have never owned gold.

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