– Bullard Says FOMC Won’t Have Clear Enough Picture for Dec. Rate Hike
– In Low Inflation, Low Rate World Fed Should Wait, Not Be Preemptive
– Balance Sheet Shrinkage To Raise Long Rates Much Less Than QE Cut Them
Written exclusively for InTouch Capital Markets
16th October 2017
By Steven K. Beckner
In a time of ferment for U.S. monetary policy, it’s easy to get the impression of a stark divide between Federal Reserve “hawks” and “doves” — with the hawks getting the best of it in terms of pushing short-term interest rates higher.
But while differences on the Fed’s policymaking Federal Open Market Committee do remain regarding the outlook for inflation and in turn the pace and timing of rate hikes, there is less difference than meets the eye. Opinion across the FOMC spectrum is increasingly coalescing around the notion that we’re living in a world of lower inflation, lower real interest rates and, hence, lower nominal rates, and a big proponent of that viewpoint is St. Louis Federal Reserve Bank President James Bullard.
This emerging consensus, while not monolithic, is reinforcing the FOMC’s inclination toward “gradualism” in raising the federal funds rate.
There is very little disagreement, meanwhile, on the need to continue to steadily shrink the Fed’s $4.2 trillion bond portfolio and to accept some increases in long-term rates — very modest ones in Bullard’s estimation. It would take a lot to derail the balance sheet reduction train.
The independent-minded Bullard helped bring this policy picture into focus for me when I interviewed him last Thursday, Oct. 12 for National Public Radio.
In a nutshell, Bullard’s argument is that the FOMC does “not have to anticipate” an acceleration of GDP growth or inflation, and “we don’t need to be preemptive.” He thinks the funds rate is about where it needs to be now and over the forecast horizon.
Bullard’s consistent message of patience in raising the funds rate is getting increasing traction, although there is still a good chance the FOMC will follow through on projections and raise it a fifth time to a target range of 1.25 to 1.5 percent in December.
When Bullard first announced in June 2016 that he and his St. Louis Fed colleagues had adopted a “new policy regime” that called for no more rate hikes, many looked askance. But these days he’s looking mighty prescient.
While he has the lowest funds rate projections or “dots” in the FOMC “dot plot,” as he freely acknowledges, Bullard is not as much of an outlier as one might think. You might even say he is on the cutting edge of a new way of thinking about policy.
Look no further than the FOMC’s September Summary of Economic Projections, in which yet again participants revised down their estimate of the longer run “neutral” funds rate from 3.0% to 2.8%. When the FOMC first started publishing its estimate in early 2012, it put the neutral rate at 4.25%. As recently as December 2015, it was 3.5%.
All this downward revision has come in the real rate component since the long run inflation projection has remained 2%. It reflects officials’ belief that GDP potential has declined due to slower productivity growth, weaker labor force growth and other forces.
The steady reduction in the projected neutral rate is no mere academic matter. It has policy consequences, especially when the FOMC repeatedly says that, even after it finishes rate “normalization,” it expects that “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”
Bullard’s basic thesis — that the U.S. and the rest of the industrialized world have entered a lasting period of more sluggish GDP growth, persistently slower inflation, reduced real interest rates and hence lower nominal rates — does not differ greatly from what a number of other officials have been saying. And it’s not just “doves” like Minneapolis Fed President Neel Kashkari, Governor Lael Brainard and other less dovish Fed presidents such as Chicago’s Charles Evans and Dallas’s Robert Kaplan who have been sounding this way.
The day before I sat down with Bullard in Washington, San Francisco Fed President John Williams declared, “The stars are aligned. They all point to a new normal for interest rates…. The new normal is likely to be 2.5 percent, and we all need to prepare accordingly.”
His “new normal” rate is the sum of the 2% inflation assumption and a 0.5% real rate or r*.
Williams, who was Yellen’s top advisor when she held his position and who has partnered with Fed Board senior economist Thomas Laubach in researching r*, was one of the first to urge that the Fed leave the zero lower bound, but last Wednesday he suggested there is limited room for further rate hikes.
“A variety of factors have pushed r-star to this low level, and they appear poised to stay that way,” he said. “The major one is that the sustainable growth rate of the economy has slowed dramatically from prior decades.”
Yellen herself is sounding considerably more cautious — not yet backing away from her base case that labor market slack will push inflation to 2% over the next few years, but acknowledging increased uncertainty about the prognosis for inflation and in turn rates.
“Because the neutral rate currently appears to be quite low by historical standards, the federal funds rate would not have to rise much further to get to a neutral policy stance,” she said in her Sept. 20 post-FOMC press conference.
Speaking six days later, Yellen lamented mounting uncertainties about the economy’s growth capacity, inflation and the real equilibrium interest rate.
“Estimates of this rate have declined considerably in recent years, and, by some estimates, the real neutral rate is currently close to zero…,” she said, adding “my FOMC colleagues and I will therefore need to continue to reassess and revise our assessments of the neutral rate in response to incoming data and adjust monetary policy accordingly.” And she added that the emergence of these “significant uncertainties … strengthens the case for a gradual pace of adjustments.”
In the same cautionary vein, minutes of the September FOMC meeting disclosed “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.”
In her latest outing, Yellen sounded even less eager to keep pushing up rates. She was upbeat in a Sunday morning speech to the Group of Thirty, predicting the economy will “recover quickly” and employment will “bounce back” from storm damage. She called faster wage gains “encouraging.”
But Yellen returned to the theme of uncertainty, noting that the core PCE is up just 1.3% year over year. She said her “best guess” is that tightening labor markets will increase price pressures, but said low inflation could “persist.” So she and her colleagues “will be paying close attention to the inflation data in the months ahead.”
What’s more, Yellen sounded more noncommittal about raising rates in the near term saying only that “additional gradual rate hikes are likely to be appropriate over the next few years.”
In the face of greater doubt, the logical policy conclusion in Bullard’s mind is to proceed very slowly.
It is widely believed that as the economy rebounds from recent storm damage, continued strengthening of the labor market will improve prospects for hitting the inflation target and justify another rate hike before year’s end.
Bullard considers that wrongheaded.
Looking toward the FOMC’s final meeting of the year Dec. 12-13, Bullard said, “We don’t need to be preemptive…. I don’t think we’re going to have enough information by the time we get to the December meeting, either on GDP or on inflation, to really be in a position to know where the economy is and what’s happening with those two variables.” He doesn’t think the Fed will have a clear picture of the post-hurricane economy until at least February.
With PCE inflation far below target, with GDP still averaging around 2% (after averaging the first and second quarters) and with job growth having slowed, even after allowing for hurricane effects, Bullard sees no rush to raise the funds rate again this year or over the next few years.
“I think we could afford to wait and see what happens,” he told me. “For those who want to argue that it will come back we can just wait and see if that’s true, and then we could make a policy decision at that juncture. So I don’t think we have to anticipate the bounce-back that people are talking about. I think we can just wait and see when it occurs.”
Bullard won’t vote again until 2019, but his voice will certainly be heard around the FOMC table.
He has always been one of the more thoughtful and innovative Federal Reserve Bank presidents. An early proponent of large-scale asset purchases, he was also among the first to urge the FOMC to start shrinking the huge bond holdings amassed in three rounds of quantitative easing.
Bullard was regarded as something of a “hawk” through early last year. So he surprised many when, despite advocating a scaling back of Fed bond holdings that could push up long-term interest rates, he began propounding his new regime of keeping short rates low indefinitely.
He sees no contradiction. He had chafed at the Fed keeping downward pressure on long-term rates by reinvesting all maturing securities while raising short-term rates, seeing no justification for raising the short end of the yield curve while depressing the long end.
Bullard’s basic argument now is that the Fed can afford to be more reactive and less anticipatory or preemptive in the current climate.
“I think we should just accept that we’re in this low interest rate, low inflation regime and that we should make optimal monetary policy within that framework for now,” Bullard explained. “And then maybe someday we’ll return to the previous regime, but I wouldn’t be preemptive on that. I wouldn’t anticipate that.”
“(W)e’re living in this world that’s a very low real interest rate world, a low inflation world, a low nominal interest rate world,” he elaborated. “Accept that and make monetary policy in an appropriate way for that environment.”
Bullard acknowledged that tax reform could quicken productivity and GDP growth, while boosting the neutral rate. If that happens, he believes the Fed may well have to make monetary policy less simulative, but sees no justification for assuming that’s going to happen.
“My main point would be that, for the purposes of planning monetary policy over a period of two years, I think you should just plan on, okay, it’s going to be more of the same,” he said.
“If better things happen that would be very welcome and we would adjust to that,” he continued. “So there is some upside risk, but I think for planning purposes you shouldn’t be announcing to people that you’re going to be raising interest rates in the future.”
Rather, Bullard advised, “You should be saying, ‘well we’re in a 2% growth world; it’s a low inflation world; we don’t really have to do anything in order to keep inflation where it is or allow it to go up a little bit; we don’t have to do anything to get better labor outcomes, so we’ll just keep interest rates where they are, and we’ll keep an eye out for higher productivity growth, higher growth of the real economy. If that happens we’ll react to it then.'”
Obviously Bullard hasn’t sold everyone on his viewpoint. After all, FOMC participants continued in the September SEP to project a third rate hike before year’s end, three rate hikes next year and three more the following two years.
Some officials posit additional reasons for raising rates besides containing inflation. Kansas City Fed President Esther George warned last week that “waiting for solid evidence that inflation will reach 2% before taking further steps to remove accommodation carries risks of overheating the economy, fostering financial instability, and perhaps putting in motion an undesirable increase in inflation.”
There are those who fret that financial conditions have not responded sufficiently to past Fed tightening. That concern has lessened somewhat with the 10-year Treasury note yield’s roughly 25 basis point rebound from early September lows, but stocks keep zooming to new highs, leading some to contend that if financial conditions don’t respond to Fed actions it’s a justification for doing more, not less.
And there are those who would simply like to put more distance between the funds rate setting and the zero lower bound to give the Fed more room to use countercyclical monetary policy. (Bullard believes the Fed already has sufficient room to fight recession when funds rate cuts are coupled with use of Q.E. and other tools used to fight the financial crisis.)
So no, the FOMC has not fully come around to Bullard’s way of thinking, but many members have moved in his direction. There are fissures in the FOMC consensus that could lead to reductions in the number of rate hikes — as indeed there have been over the past two years. Bullard may be the canary in the mineshaft in that regard.
With the Fed trimming its bond holdings by $10 billion per month and ultimately by $50 billion per month, there is concern that long-term interest rates will spike, but Bullard sees little cause for concern.
Bullard would have preferred that balance sheet reduction be more data-dependent and less “on automatic pilot,” but is pleased the FOMC finally implemented its balance sheet reduction in October, and he sees little danger of a spike in bond yields.
For one thing, he said, “there is an argument that the decline in the balance sheet is not nearly as important as the rise in the balance sheet.”
That’s because, as he explained, when the Fed was heavily buying bonds, it was taken as a signal that the FOMC would not be raising the funds rate, and that helped hold down the whole yield curve. Now that the Fed has raised the funds rate four times since December 2015, reducing the balance sheet has no signaling value for the path of the funds rate.
Federal Reserve Board economists have concluded that Q.E. reduced long rates about 100 basis points, but Bullard doubts very much that unwinding Q.E. will have a similar effect on the upside.
Bullard cast doubt on such estimates and questioned whether reducing reinvestments and rollovers will have “any impact,” He cited St. Louis Fed research predicting only limited increases in long rates. His Bank’s staff estimates a 25 basis point increase in long rates over two years under the balance sheet reduction plan the FOMC launched at its last meeting.
“So that’s one basis point per month or so…,” Bullard remarked. “Of course, it’s very uncertain, but I think that that’s such a small number that it just gets lost in all the noise…. I think that with all the other things that drive long-term raise rates up and down you wouldn’t notice the one basis point per month.”
Some would undoubtedly argue that the less long rates rise the more the Fed will have to raise short rates, but that’s a battle for another day that Bullard will be only too happy to join.
Prior article by Steven Beckner for InTouch Capital Markets: FOMC Minutes Could Give Insight on Monetary Policy Big Picture
Steven Beckner is a veteran financial journalist with four decades of experience of reporting on the Federal Reserve. Mr Beckner is the author of Back From The Brink: The Greenspan Years (Wiley, 1997) and can also be heard speaking regularly on National Public Radio.