Tuesday, June 12, 2018

The Fed hasn't yet begun to tighten

Tomorrow we'll likely learn that the Fed is raising its target funds rate (and the rate it pays on excess reserves) by another 25 bps, to 2.0%. It won't be surprising, and it shouldn't pose any threat to financial markets. That's because this latest hike is necessary just to keep monetary policy "neutral." In fact, the Fed has been in neutral for the past year. How is that? Because the economy has been gradually picking up steam over the past year, and inflation is up as well. A modest pickup in growth and a modest rise in inflation fully justify a modest rise in rates. Indeed, it would be worrisome if the Fed doesn't raise rates tomorrow.

Chart #1

Chart #1 is an update of a chart I've been following for years. It shows that over time there is a correlation between the pace of real economic growth and real interest rates. Very strong growth (4-5%) in the late 1990s was matched by very high real yields (4%). Since then the economy has been downshifting, with growth in the current business cycle averaging a little over 2% and real 5-yr yields meandering around zero. Growth has picked up of late, however, and so have real yields. Current estimates for Q2 growth are roughly 4%, and if that proves to be the case, then real growth over the past year will have been about 3%. (The chart shows the 2-yr annualized growth rate, to better track the recent "trend" which I project will reach 2.6%.)

If growth continues to accelerate, as I expect it will (but the market is not yet convinced of this), then real yields could rise to the 2-3% range in a few years. That would of course imply a lot more Fed rate hikes than the market is currently expecting.

Chart #2

Chart #2 compares the real yield on 5-yr TIPS to the real, inflation-adjusted Fed funds target rate—which is the only rate that really matters to the markets and the economy. I've projected the real funds rate to rise to about 0.1% by the end of this month. Note that the real funds rate has been relatively stable for the past year; 3 rate hikes have been necessary simply to offset the rise in inflation.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS with the "Natural Real Rate" as calculated by the Laubach-Williams method. This is "the rate interest rate consistent with output equaling potential and stable inflation." In short, it's one way of estimating what the real Fed funds rate should be if the economy is operating at or near its potential and inflation is stable. Note that 5-yr real yields (which can be thought of as the market's forecast for what the real fed funds rate will average over the next 5 years) are effectively projecting that the Fed will "tighten" monetary policy only moderately over the next several years, in a manner consistent with inflation remaining stable and the economy picking up a little speed. The Natural Rate should rise as the economy picks up speed.

Chart #4

Chart #4 compares the real funds rate with the Natural Real Rate. It's likely that the Fed keeps an eye on the natural rate, and manages the real funds rate accordingly. If they need to "tighten" policy they push the real funds rate above the natural rate, and if they need to "ease" (as they did for most of the current business cycle), then they push the real rate below the natural rate. The two lines converged in June of last year, which can be interpreted to mean the Fed decided in early 2017 that the economy no longer needed policy "stimulus," and therefore monetary policy should shift to neutral. (I'm not endorsing this way of thinking, merely commenting on how it might work.)

Chart #5

It's worth repeating Chart #5, to make the point that it takes very tight money policy to precipitate a recession. Tight monetary policy shows up in the form of very high real short-term rates and a flat or inverted yield curve. We're a long way from seeing those two conditions repeat. The current shape of the yield curve is still upward-sloping, which means only that the market expects the Fed to continue to raise short-term rates for the foreseeable future. That's not remarkable or in the least scary. Besides, real interest rates are still unusually low.

Chart #6

Chart #6 compares the nominal and real yields on 5-yr Treasuries, with the bottom line being the difference between the two, which is the market's implied forecast for what the CPI will average over the next 5 years. Happily, inflation expectations are only slightly above 2%, which is fully consistent with the Fed's objectives and fully consistent with stable inflation. If the Fed is going to hike rates significantly, we'd first have to see stronger growth and/or rising inflation expectations.

Chart #7

The CPI ex-energy, shown in Chart #7 has actually been very stable around 2% for the past 15 years. I justify taking out energy prices because they are by far the most volatile of all commodity prices, and it makes no sense for the Fed to try to control energy prices. And in the long run, there is not much difference between the full CPI and the ex-energy CPI.

Chart #8

Chart #8 shows the history of the CPI and the ex-energy CPI, using a 6-mo. annualized calculation to focus on recent trends. Note the huge amount of volatility imparted to the full CPI just by adding energy prices, even though energy represents less than 4% of personal consumption expenditures. Over the past 20 years, the full CPI has averaged 2.2% per year, while the ex-energy CPI has averaged 2.0%. 

Chart #9

One of the least-remarked developments on the inflation front is arguably the disappearance of deflation from computer prices. Chart #9 shows how prices for computers and peripherals were falling 30% per year about 20 years ago. So far this year, prices have been stable, for the first time ever.

Chart #10

One reason to expect stronger economic growth is shown in Chart #10. Small business optimism has never been higher than it is today. Entrepreneurs are excited about lower tax rates and a substantial reduction in regulatory burdens. This should translate into more investment, more jobs, and higher productivity (which has been sorely lacking during the current business cycle).

Chart #11

Chart #11, another perennial favorite, shows how every major increase in the market's level of concern and uncertainty has coincided with a sharp selloff in equity prices. Once fears subside, prices float back up. The same cycle has repeated a number of times in recent years, and we're at the tail end of the most recent.

Chart #12

Chart #12 compares the Core measure of consumer price inflation (ex-food & energy) with 5-yr Treasury yields. Normally the two should move together. That relationship broke down in 2011, however, when the market started worrying about the collapse of the Eurozone, the fiscal cliff, China, oil prices, Brexit, and the US election, successively. Risk aversion throughout most of the current business cycle drove strong demand for Treasury yields, keeping them unusually low relative to prevailing inflation. Now we're getting back to normal. Higher interest rates are not scary, they're to be expected.

I don't think the Fed is going to be a source of concern for the market for the near future. But if the economy heats up, the Fed governors are going to be wringing their hands and losing sleep at night. And if inflation expectations rise, well, then we'll all start to worry. But for now the main thing to watch is the economy, which should continue to show signs of faster growth. (See my last month's post "Waiting for GDP") If I'm right and GDP growth accelerates convincingly above 3-3.5%, then the Fed is going to have to raise short-term rates, and bond yields are going to have to rise as well, and both by much more than the market is currently expecting. Will higher interest rates kill the economy? No, because they will be the natural result of a stronger economy. Interest rates will only become a concern when the Fed thinks it needs to step on the brakes and raise real rates significantly.


Anonymous said...

Excellent post. I really like the new data on the natural rate relating to GDP potential and the tidbit about computer deflation. I really enjoy your work. Thanks!

TJ33A said...

Really enjoy reading your articles. Thanks for sharing your thoughts and analysis.

hayuen51@gmail.com said...
This comment has been removed by a blog administrator.
steve said...

Good piece Scott but given that assuming the Fed raises rates today it will be the SEVENTH rate hike I'm not sure the title of the piece isn't somewhat spurious.

Scott Grannis said...

steve: yes, this will be the seventh rate hike, but my point is that this does not necessarily equate to a tightening of monetary policy or conditions. The moved from being accommodative to being neutral. They have adjusted rates higher in a following response to improving conditions in the economy and a modest rise in inflation.

If inflation suddenly surged to 5% and the Fed moved its rate target from 2% to 3%, would that be a "tightening" of monetary policy? I would say most definitely not, because real yields would still be very negative. A tightening almost has to involve higher (and positive) real interest rates.

ckhajavi said...

Scott - anything surprising about the Powell’s forward comments today - general interpretation was that it was a bit more hawkish than expected but not that surprising - curious what you think - thanks

Benjamin Cole said...

Great wrap-up.

I love Chart #4, although I am not sure why the "natural real rate" has died at 0%.

It does seems if the US and global economy have moved into an era of lower real interest rates.

Kevin Erdmann (Idiosyncratic Whisk) has been posting CPI sans housing, and it is a worthy chore. Without housing, the CPI is stuck at 1%.

The bulk of inflation today is arguably due to tight property zoning, and NIMBYism, which is a strange alliance of the propertied-financial class, and left-wing greenie-weenies.

A house in Seattle will set you back $820,000. That is a house a machinist bought (no working wife) 50 years ago.

If the Fed wants to cool off the economy, they will have to figure out how to do it without torpedoing property prices. A replay of 2008 we can do without.

As always, a fascinating post by Scott Grannis, and a fascinating topic.

OT but maybe not: The Bangkok Post reported "massive capital outflows" from Thailand when the 10-year US Treasuries offered 3%. The Fed can raise rates, but many other nations might be forced to do so also, perhaps suffocating growth.

Grechster said...

Chart #2 continues to be one of the most important... and it looks better than it did a few short months ago.

Thanks for the update, Scott.

I wish I was as copacetic as you on the 2-10 spread... 38 bps right now.

steve said...

AS DT's inane trade tariffs gain traction, the fed will increasingly be in a conundrum. As some point-probably in the near future, the market will wake up and realize that DT and his sycophants are serious about protectionism. DT will NOT alter his course. He is obviously intransigent and it is not unreasonable to expect dire consequences when small tariffs become something more than that. Given that the state of the US economy is so strong right now it seems as Scott pointed out a short time ago that DT is trying his best rip defeat from the jaws of victory.

I have a bad feeling about what might happen as the fed continues to ratchet up rates and the markets figure out that DT and cronies don't have a freakin clue what they're doing re trade.

Scott Grannis said...

Re Trump and trade policy: Tariffs are really stupid, since they hurt all consumers but "help" only a few producers. I hate Trump's imposition of tariffs on Chinese products. But I have to believe that he is negotiating in pursuit of lower overall tariffs. Trump made a very important admission the other day, when said, in effect, that in an ideal world there would be no tariffs and no subsidies. Free trade for all is indeed the ideal. I think that's where he wants to go, but first he has to get China's attention by threatening tariffs and actual imposing them if necessary. If China backs down, so will Trump. That may or may not be an ideal strategy, but only time will tell.

steve said...

OK, but what if China doesn't back down? And BTW, it's not just China is it? But what really bothers me about this mess is it smacks of cronyism and picking winners and losers is a failed left wing agenda.