Thursday, March 22, 2018

The Fed is not tightening monetary policy

Yesterday the FOMC raised its short-term interest rate target (and the rate it pays on bank reserves) to 1.75%. This move was widely anticipated, and so it matters little. Regardless, monetary policy is nowhere near being "tight," and the Fed's plan to raise rates by another 100 bps or so over the next year is not necessarily a cause for concern. The tightness of monetary policy should always be judged in real terms (i.e., by subtracting inflation from interest rates—higher real yields increase the demand for money and when they get high enough, eventually slow economic activity). Yesterday's rate hike has already been offset by a recent rise in inflation (the PCE Core deflator rose 1.52% in the 12 months ended January, and my estimate has it rising 1.8% in the year ending this month). As result, in the past year, real interest rates have only risen modestly, in synch with a modest pickup in real growth, much as theory would predict. In short, the Fed is following the market's lead, and adjusting real rates higher in line with somewhat healthier growth. This not only makes sense, it's a welcome step in the right direction.

However, while monetary policy isn't currently threatening, trade wars are indeed a cause for concern. Trump is engaged in brinkmanship with China, in an attempt to force China to respect intellectual property rights and reduce punitive tariffs on some US exports to China. Today, some Chinese officials threatened retaliatory tariffs on US exports, particularly grains, and that raised the stakes, which in turn explains why the market fell meaningfully. Nobody benefits from tariff wars, particularly a tariff-imposing country's own consumers. If a tariff war were to escalate—heaven forbid—the results could be devastating, as happened with the Smoot-Hawley tariffs and the Great Depression. But everyone could benefit from freer and fairer trade, and I think that's what Trump is aiming for. If we've learned anything about Trump in the past year or so, it's that he is a clever negotiator who scares people from time to time. He undoubtedly believes that you've got to take great risks to achieve great results.

While we nervously await the outcome of the Trump vs. China war of nerves, it's helpful to remember that the growth fundamentals of the US economy are "beautiful," to borrow a phrase. Corporate tax cuts have set the stage for a significant pickup in investment, jobs growth, and real incomes, but it will take awhile before we see the results. The outlook is promising, but we're sweating through a lot of uncertainties at the moment. I think it pays to remain optimistic, but it's clear that uncertainty and risk are a bigger factor today than they have been in more than a year.

Here are some charts which are relevant to my comments above:

Chart #1

Chart #1 is number one on my Recession Watch list. It shows that recessions have always been preceded by a severe tightening of monetary policy. That tightening in turn consists of 1) real short-term interest rates of 3% or more, plus 2) a flat or inverted Treasury yield curve. Currently, real rates are  still unusually low, and while the yield curve has become a lot less steep in recent years, its current slope is consistent with continued growth. The curve is positively sloped because the market believes the Fed will indeed raise rates in coming years, though not excessively.

Chart #2

Chart #2 compares the real yield on 5-yr TIPS (red line) with the real Fed funds rate (blue line). The former is effectively equal to what the market believes the latter will average over the next five years. Thus, the market currently expects only a modest amount of monetary policy tightening for the foreseeable future. That is normal, and it is consistent with the slope of the nominal Treasury yield curve.

Chart #3

Chart #3 shows how real yields (blue line) have risen gradually and in line with a modest strengthening of real GDP growth. It also suggests that if economic growth were to accelerate meaningfully (e.g., 3-4%), then we should expect to see real yields move up to at least 1.5-2.0%.

Chart #4

Chart #5

Industrial production is booming, both here and in the Eurozone, as Chart #4 shows. And it's not just utilities, as Chart #5 shows: after subtracting utility output from the IP data, we see that manufacturing output has in increased meaningfully in the past year, after several years of only modest gains.

Chart #6

Billings at major architectural firms have also picked up in the past year, as Chart #6 shows. There is a lag of at least 9 months between a pickup in billings and the resultant pickup in construction, so this is a good leading indicator of better news to come in the commercial construction sector. 

 Chart #7

Chart #7 compares an index of truck tonnage (orange line) with the S&P 500 index (white line). I like the truck tonnage index because it is a fairly contemporaneous measure of the physical size of the economy]Both have improved significantly in the past year or so, and both have dipped of late.

Chart #8

Skeptics call Chart #8 the "mis-" leading indicators, since this series doesn't do a good job of anticipating important changes in the economy. It's best thought of as a good contemporaneous indicator. In any event, the Leading Indicators index is up 6.5% in the year ending February, and that is a pretty good indication that we are still in the growth phase of the current business cycle.

Chart #9

When talking about debt and deficits, it is imperative to express them as a percent of economic activity. Chart #9 does just that, showing the federal deficit as a percent of nominal GDP. Although the $706 billion that the government has borrowed in the past year sounds like a lot, it is a smaller percentage of GDP than the Reagan deficits were in the 1980s. Another thing to note about this chart is that the burden of deficits (their size relative to GDP) always declines during periods of growth, while it always increases during periods of economic weakness. Growth is the key variable when talking about debt and deficits. I've explained before that the deficit has been increasing of late not because the economy has been weak, but rather because people have been anticipating tax reform and consequently accelerating expenses and postponing income. Now that tax reform is not only a reality but significantly pro-growth, we should see faster economic growth, more jobs, and a bigger tax base that should ultimately result in an improving fiscal situation (i.e., a declining deficit/GDP ratio).

This is not to ignore the long-term risks to the fiscal outlook, which center around the growth of entitlement spending. We're not yet on a collision course with fiscal disaster, but that remains a major source of concern for the long haul. In the meantime, more growth would mitigate those concerns.

Chart #10

Chart #10 shows how market worries (as proxied by the red line, which is the ratio of the Vix "fear" index to the 10-yr Treasury yield) have affected stock prices. The current "wall of worry" is not too high; we've seen much worse in recent years.


ckhajavi said...

Scott - China responded with 3bn in tarrifs on aluminum, pork, wine and steel but said they want dialogue. I think the key is how trump responds - if he escalates then the risks start to grow quickly - do you really think he’s this strategic to take us to the brink and then pull back? Seems like China willing to negotiate but trump fighting mueller and surrounding himself with guys like Bolton so I’m getting incrementally more nervous about his ability to pivot here - thoughts?

Scott Grannis said...

If Trump's strategy is to work, he has to make most people very nervous, just as you are. It's mutual assured destruction. You have to make the other guy believe you are serious, and that's the only way to avoid war. Negotiating from strength can be nerve-wracking but it can also be effective. I can only hope it works out the right way.

ckhajavi said...

Well he’s done a good job making me nervous - if you listen to Wilbur Ross speak today it’s clearly a public negotiation and he “promised” they aren’t going to blow up all the good things they have accomplished thus far - feels like the ride will be bumpy but I agree it will likely pay to remain optimistic - thanks for the quick response

John said...

Mr. Grannis:
Apparently dollar-Libor rates are higher than they've been since 2008. What's going on? Why should this be happening and how will it play out in the financial markets, in your opinion?

Bert Hancock said...

Good question John. 6 mo Libor is at 2.34%! What's up with that?

This dovetails with my own question... Scott, you say the Fed isn't tightening, but when I look at the 5 year TIPS yield hitting 0.7%, it shows a distinct upward trend. I am probably not going to articulate this very well, but hypothetically, what level of Fed Funds and TIPS yield would make you concerned (assuming GDP and inflation remain at current rates of growth)?

I see inflation in my industry (construction materials and labor) that are exceeding 5% per year. Yet the statistics don't show much inflation. I'm baffled. Everyone I know has to pay big wages to hire decent people. When will the statistics show what's really happening in housing and labor?

Ok. That's two questions...

Bert Hancock said...

I guess that's three questions if you include my shared observation about LIBOR. Cheers!

Benjamin Cole said...

I can't say Chart #5 thrills me. Looks like a senescent nation.

Chart #9 is not encouraging either.

Many nations have thrived with some degree of protectionism, indeed China is booming now.

I cannot imagine some trade tariffs harming the US economy, endowed as it is with immense amounts of capital and talent. May even help. BTW Doug Irwin says the Smoot-Hawley tariffs did not bite much.

As Milton Friedman said, the Fed did it (the Great Depression that is, also the The Great Recession).

Will the Fed over tighten? That is 100 times as large a threat to US prosperity as trade tariffs.

Along the West Coast, the threat of US prosperity and growth is property zoning, not trade tariffs.

Can a nation that consistently consumes more than it produces, and sells assets or goes deeper into debt to pay for living well, really prosper in the long run?

We will see.

Benjamin Cole said...

A gripe:

OPEC, as we speak, is openly colluding with other oil-exporters to limit production, and gouge consumers. Free markets are not even on the table. That is not a trade war.

China is a mercantilist, protectionist, communist nation that subsidizes exports, and uses prison and slave labor. That is not a trade war.

But the US imposes import tariffs.

That is a trade war.

steve said...

Scott, you give Trump WAY too much credit for being clever re trade tariffs-or much anything else. He strikes me as an petulant adolescent. His personal behavior is appalling and all i hear from his supporters is how good a negotiator he is. The market is right to be nervous...

John said...

He said he wanted to be unpredictable. He announces tariffs then exempts many countries. He says he may veto the budget, then signs it and says he'll never sign anything like that again. Whether he intends to or not, he is dangerously messing with markets, needlessly rattling investor confidence, in my opinion.

xr-3609 said...

Scott is correct, if Trump is not making the market nervous; he is not doing his job in this regard. Wilbur Ross was the good cop, it is significant that he shared the stage.This has been going on for decades. Bush could not fix it, nor Obama.

Really great and timely post, congratulations Scott!

marcusbalbus said...

sometimes you 're the windshield and sometimes you're the bug.

Scott Grannis said...

Re Libor. The spread between 3-mo Libor and 3-mo T-bills (The "TED" spread) has risen significantly in the past few weeks. Ordinarily a rising TED spread would be symptomatic of trouble brewing in the banking sector (Libor is what banks must pay to borrow money, so the higher the spread, then presumably the lower the credit worthiness of the bank that wants to borrow). But I don't see other indications that banks are in trouble. I think the explanation has to do with all the corporate cash that is being repatriated from overseas (i.e., Trump's tax reform is the culprit). Lots of money is moving around, and corporations are changing the way they invest and borrow, and this is creating temporary strains in the banking industry. If I see a good/better explanation on the web I'll post a link here.

Scott Grannis said...

Re what would it take to make me worry about Fed tightening. At least three things: 1) a real Fed funds rate (the Fed's target less the rate of PCE core inflation) of at least 3%, 2) a flat or inverted Treasury yield curve, and a significant rise in swap spreads. I might also begin worry if the 5-yr TIPS real yield was equal to or less than the real Fed funds rate, since this would be a sign that the market is expecting the Fed to ease in the future, presumably because they have been too tight and the economy is at risk of slowing down. So far none of these conditions prevail.

Johnny Bee Dawg said...

The Republican Spending bill is crashing markets. And the fact that Trump signed it.
Massive new debt and policies that throw sand in the gears of growth.
The Fed wont have to raise much more now. This puts us back on the Obama trajectory.

DEMs got every single thing they wanted, and the voters who put Trump and the PUBs in control of the entire government got screwed HARD. Super hard.
And now a million people nationwide are out marching and protesting against the Bill of Rights.

MAGA got a mortal wound this week, and markets know it.
Trump likely lost his base, and ensured himself a single term. Markets saw that, too.
It was only a blip. We are on pace to deliver the worst 30 year market return in US history.
Markets wont do well with back to back decades of Socialism.

John said...

Sorry, I can't resist.
Regarding Chart 9: Mr. Grannis rightly points out " Another thing to note about this chart is that the burden of deficits (their size relative to GDP) always declines during periods of growth, while it always increases during periods of economic weakness.

Take a look at Chart 9 and consider which Party held the White House (and the keys to the Treasury) during those periods when the burden of deficits was increasing or decreasing.

Divided government, with the Dems in the WH and Reps controlling Congress has worked pretty well.

Charlie said...


Well, looking at the slope in Chart 9 (improvement vs worsening), I'm not so sure that divided government makes that much difference. It seems to be correlated with WH party alone.

But of course, correlation isn't causation, except when it happens to line up with one's own political orientation.

Ataraxia said...

For anyone who has not seen it, here's an article on Libor jumping.

Scott Grannis said...

Matthew: thanks for the link, it does a good job explaining what's going on with the Libor-OIS spread in plain language. I would add that Libor spreads (Libor vs 3-mo T-bills and vs OIS) appear to have stopped widening. The TED spread (Libor vs 3-mo T-bills) has actually dropped from a high of 57 bps last Friday to 54 today. I think this supports the thesis that the unusual widening in Libor spreads was not evidence of deteriorating conditions in the banking sector, but rather due to unusual and widespread changes in corporations' preferences for holding cash vs. short-term assets. Libor rising is a two-edged sword, of course: some have to pay more, but others get to receive higher interest rates. In the absence of any real systemic problems, markets should eventually react to unusually high interest rates (savers rush in, borrowers slow down) and there is now some evidence that arbitrage forces are beginning to work. I note also that 2-yr swap spreads have dropped from a high of 34 bps yesterday to 28 bps today. At 28 bps, swap spreads are firmly in "normal" territory, further suggesting that widening Libor spreads were anomalous.

ckhajavi said...

Scott - the yield curve keeps flattening at a fairly brisk pace - we haven’t been this flat since 07 - when do we start to get concerned?

Scott Grannis said...

Cameron: today the yield curve is a few basis points flatter than it was 3 months ago. It still has a reasonably positive slope, consistent with an economy that is still in its growth phase. The market still expects the Fed to raise short-term rates over the next few years or so. I would begin to worry when and if the market began to price in rate cuts, especially if swap and credit spreads were widening significantly. So far neither of those conditions holds.

ckhajavi said...

Harker just said they are willing to slow there pace if the curve doesn’t steepen - the fed is obsessed with not causing a recession this time around so I’m not that concerned unless it becomes clear inflation is running faster than anticipated which I think is low likelihood / supported by your work - on a separate but similar topic it’s much harder for the curve to invert at these low levels - last time we were this flat rates were 350bps higher - don’t think Japan has had an inversion for a very long time

Scott Grannis said...

Cameron: good point. As I've argued for a long time, the Fed is a follower, not a leader. A flat or inverted curve would be the market's way of telling the Fed that they are being too aggressive with rate hikes. Since there is no reason to tighten in order to bring inflation down (at least for now), I don't see why the Fed would persist with rate hikes if the market is saying they would harm the economy. So the risk of a Fed-induced recession is low, at least for now.

As it is, today's modest upward slope to the yield curve is the market's way of saying that the economy is not expected to accelerate significantly, and thus the market doesn't expect the Fed to tighten too much. If that were to change, however (i.e., if growth expectations were to surge) then I would fully expect the yield curve to steepen, and for the Fed to take notice and step up the pace of rate hikes.

honestcreditguy said...

the 10 yr at 2.92 or above is causing some concern, thus the market sell off on any such move, its happened 3X in last couple weeks. the big boys don't like the 10 yr creeping up like this with spring house selling getting set to kick in.....everything is toppy as we speak....inflation is being masked extremely well....WTIC on course to find gap at 74 this spring.....a managed economy....the fed fools in action

Salmo Trutta said...

Understand one thing, the Fed has tightened money policy. R-gDp has now flat lined and bottoms in April. Inflation will continue to decelerate throughout the rest of this year.

The Fed's technical staff thinks money is neutral in both the short and long run. They don't know the difference between tight or easy. But I do, and have, since July 1979.

The problem with M2 is a problem with non-M1 components. Savers are dis-saving. They are not reinvesting the proceeds. The US will enter a prolonged economic depression, one in which it may never recover.

But the solution is simple. Drive the DFIs, deposit taking, money creating financial institutions completely out of the savings business. This is exactly the opposite strategy since 1957.

All bank-held savings are lost to both consumption and investment until their owners spend/invest directly or indirectly, e.g., via a non-bank conduit.

This macro error is both the source of stagflation and secular strangulation. I.e., DFIs, from the standpoint of the economy and system, do not, can not, loan out existing deposits, saved or otherwise.

-Michel de Nostredame

Unknown said...

Hi Scott,
Thanks for posting the material you do, it's thoroughly enjoyable, and helpful to read.
One request though, do you think you could spread the portion of the page that includes the text to become a little wider (with slightly larger text)? Or perhaps i'll just visit the optometrist.

Appreciate it.