Thursday, August 1, 2019

A non-fatal Fed mistake

Yesterday the FOMC decided to reduce its short-term interest rate target by 25 bps. It was a move in the right direction (as I suggested in late May), but as today's market action demonstrated, it was an overly cautious move, particularly in light of escalating global trade tensions (i.e., Trump's tariffs, which today he threatened to ratchet higher). The US economy, as well as most major global economies, are facing headwinds, uncertainties, and slower growth, all of which have increased risk-aversion and the demand for money equivalents. A 25 bps cut to short-term interest rates helps offset the world's increased demand for money (by making money and money-equivalents less attractive), but only partially.

A bigger cut would have been better, but this was not a fatal mistake. Why? Because the level of real interest rates remains relatively low, and liquidity conditions—thanks to the still-abundant supply of excess bank reserves and the low level of 2-yr swap spreads—are still quite healthy. The market is likely to be on edge for awhile, but there is still time for the Fed to correct this mistake and/or for trade tensions to dissipate and risk-aversion to recede.

Chart #1

Chart #2

Chart #1 shows 5-yr real and nominal interest rates, and the difference between the two (green line), which is the market's expectation for what the CPI will average over the next 5 years. Interest rates have declined significantly so far this year, but inflation expectations have only subsided slightly. That's because the most important decline in interest rates has been in real yields, which are a proxy for the market's expectation for future economic growth rates, as Chart #2 suggests. Real yields are down because the market is losing confidence in future economic growth prospects. Inflation expectations have also subsided somewhat, which further suggests that the market thinks monetary policy is a bit too tight.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS (the best measure of market-based real yields that is readily available) with the real Fed funds rate (which is the current Fed target rate minus the rate of core PCE inflation over the past year). Bond market math dictates that the red line is what the market expects the blue line to average over the next 5 years. The market is expecting further Fed rate cuts—about 2-3 more at the present time—over the next year. This is the market's way of telegraphing to the Fed that monetary policy is too tight and that lower interest rates are needed. Note also that the blue line marks the very front end off the real yield curve, while the red line marks the intermediate area of the real yield curve. When the blue line exceeds the red line, the real yield curve is inverted (as it is now), and that is a good indication that the economy is likely to slow down. Inverted yield curves are almost always a sign of slower growth to come.

Chart #4

But the shape of the yield curve is not the whole story. The other important part of the story is the level of real yields, which is shown by the blue line in Chart #4. In the past, every recession has been preceded by high real yields and a flat or inverted yield curve. Today we have only one of those indicators: the shape of the yield curve, which is slightly inverted. Real yields remain historically low. thus, a recession is far from inevitable.

Chart #5

Prior to the Great Recession, the Fed had only one way to tighten monetary policy, and that was to reduce (or increase) the supply of bank reserves. That typically resulted in higher (or lower) short-term interest rates. Today, the Fed doesn't need to increase the supply of bank reserves in order to force short-term interest rates lower. It simply declares that it will pay a lower rate of interest on excess bank reserves, which, as Chart #5 shows, are abundant—to the tune of almost $1.5 trillion.

Chart #6

With bank reserves still abundant, swap spreads are still very low, as Chart #6 shows. This means that liquidity conditions in the financial market are very healthy. Nobody is being starved for money. Money in fact is now easier to get thanks to lower interest rates. This is a very important difference compared to prior episodes of monetary tightening or easing. Things are VERY different this time around.

It's a mistake to think that although it appears that today's monetary conditions are a bit tight (e.g, inverted yield curve, lower prices for risky assets), the economy is at risk. The Fed doesn't need to reduce interest rates in order to "bail out" the economy or to give it a shot of stimulus. The purpose of adjusting short-term interest rates lower under the current monetary regime of abundant excess reserves is not to "stimulate" the economy but rather to keep the supply of money in line with the demand for money. That, in turn, will keep financial markets healthy, avoid asset price bubbles and keep inflation low and relatively stable. Remember, monetary policy was never meant to stimulate or throttle growth. Growth is not created magically when the Fed lowers interest rates. Monetary policy is meant to keep the supply and demand for money in balance, and thus to deliver low and stable inflation, which in turn is conducive to growth.

The Powell Fed was too cautious in its decision yesterday, but it was not a fatal mistake.


Roy said...

Well, the GOP just announced more tariffs and who knows what other indirect taxes they will come up with. Would you estimate that this hastens the next rate cut? How can the Fed have any idea how to act in this environment is beyond me...

Scott Grannis said...

The collective wisdom of the market trumps the wisdom of the FOMC members. They need to pay attention to the message of the bond market. That should be a very important part of their deliberations. Right now, the bond market is telling the Fed that more rate cuts are needed.

Grechster said...

Thanks, Scott. Chart #3 continues to be very daunting.

Grechster said...

Question to Esther George and Eric Rosengren: How do you explain chart #1? #3?

(Hint: The Phillips Curve and the level of the S&P 500 are no help.)

steve said...

"The collective wisdom of the market trumps the wisdom of the FOMC members. They need to pay attention to the message of the bond market. That should be a very important part of their deliberations. Right now, the bond market is telling the Fed that more rate cuts are needed."

Spot on, Scott. The question is, WHY is the bond market screaming for more cuts? I posit that our POTUS position on trade is stifling investment and therefore growth and causing havoc to CEO's decisions on what to do with earnings. I further posit that POTUS does not want a trade deal. He wants tariffs and his position could easily cost him the election as the economy is on a slippery slope.

Rich said...

It seems like Trump wants more Chinese purchases of agricultural products, believing that impacts his constituency, more than anything else.

I cannot recall the president (ugh) catering more to his base and ignoring the American people as a whole.

He has made Powell’s job nearly impossible.

Benjamin Cole said...

Great post, and I love the numbered charts, especially chart number 3.

I think the impact of Trump's tariffs is overrated, possibly by a factor of 10 to 1. Even Trump's latest tariff threat, that is 10% on $300 billion of annual China exports to the US, amounts to a tax increase of $30 billion. The United States collects annual tax revenues of $3.9 trillion. The Chinese currency, the Yuan, has depreciated against the US dollar by 10% this year anyway.

The multinationals have unlimited funds to pour into media, advertising, PR, think tanks,academia, lobby groups, trade associations, and even directly into political campaigns. Yes, trade tariffs are a structural impediment. They are a rather insignificant structural impediment compared against, say, property zoning.

President Trump has been right. The US Federal Reserve should have a much more accommodative monetary policy, if only to decrease the value of the greenback on international exchange markets.

Side note: US based multinationals report profits in dollars. When the dollar is cheaper they have larger overseas earnings as reported. A stronger dollar, paradoxically, not only decreases US exports but decreases reported profits.

Benjamin Cole said...

Add on:

Large free economies are generally very resilient in response to trade issues.

Imagine this: Let us say s year ago, the Communist Party of China, and President Xi, decided for ideological reasons to do less business with capitalist USA. So they started applying quotas on exports to the USA.

Does anyone imagine that the negative effects of such commie quotas would be but fleeting and derided as ineffective--in fact, a boon to US-based or other international businesses that quickly moved into the gap?

Trump has not applied quotas, only tariffs.

BT, if you want an unvarnished view of President Reagan and trade, read this from Mises Institute. Reagan makes Trump look like a piker! The economy flourished under Reagan (and D-party Congress, much of the time).

Both Nixon and Reagan applied quotas on auto imports. This is one reason today why large pick-up trucks, the best in the world, are still made in the USA.

Call me a free-trade skeptic.

Bùi Minh Trading said...
This comment has been removed by the author.
steve said...

Benjamin, I agree with 90% of what you write but on DT's trade policy I am really shocked that you are so insouciant. A tariff is a tax on the consumer. Period. Moreover, it is a slap in the face of freedom as it attempts to force buying decisions. There was a great piece recently written about Fender guitars made in various parts of the world (see below). The gist is if you by the American version it will cost X but if you buy the Mexican or Chinese version (still damn good instruments and Yes, I am a life long player) they cost X-Y. Trump wants to eliminate that choice. Well F You, Mr President! Maybe I can't afford the BEST Fender! It just pisses me off that a POTUS could be damn arrogant as to attempt to force buying decisions.

Am I the only one who recognizes this?

randy said...

Benjamin: regarding how seemingly small the tariffs are in context to the larger global economy... if someone stands on the side of the pool and in front of everyone pisses right in, it doesn't amount to much, but everyone sure thinks twice about jumping in after that. EVERY global businessman trying to make plans has to deal with the uncertainty of how trade policy may change. Not just those that are currently affected. It's an awful less than zero sum game of Trump choosing some domestic winners at the great cost of domestic losers.

There seems to be an increase in overly-complicated, tortured explanations for why the pet economic position is really OK. Like MMT (at some point debt does have meaning) and protectionist trade policy. I'm not buying it.

randy said...

For those arguments that the Chinese are cheating us - of course they are! That should be viewed as the cost of doing business with them! We can and should be more judicious in how we engage so that we protect IP and domestic security. But broad protectionist trade is a very blunt tool for that.

Benjamin Cole said...

Steve and Randy: yes, my views on trade are not orthodox. However, there are lots of reasons to be concerned about large and chronic current-account trade deficits.

The oldest law, that which predates even society and the study of macroeconomics: if you want to consume you got to produce.

steve said...

Where does it end?

Answer; it doesn't.

Randy's comment was spot on re China cheating us. Trade wars are the ultimate in stupidity and plain frustration. Does anyone in their right mind actually believe that China will back off? Why should they? They don't have elections! They can wait it out. This is a loser-for everyone but especially US consumers for which DT doesn't give a damn.

The Cliff Claven of Finance said...

Hey Johnny Bee (lap)Dawg:

The S&P 500 index is now (1:40pm August 5, 2019)
lower than it was on january 26, 2018

2873 (1/26/18 peak) versus 2856 (at the moment)

What do you, Trump lapdog, and perpetually bullish investor, say now?

Johnny Bee Dawg said...

Same thing I’ve been saying. The Fed screwed up and the curve is screaming they’re too tight.
Yellin was the culprit in Jan 2018. Powell crashed it again during his Q&A on Fed day (down nearly 500 in 15 minutes) when he indicated a “one and done” attitude.
I guess you don’t read any of my prior answers to you on this topic. Or just don’t understand them.
Willful ignorance?

I hit all time highs on August 8, as I was up more than you would believe that day. Way more.
Down less than market yesterday.

God Bless Donald