– Don’t Invert Yield Curve When No Inflation, Financial Risk
– ‘For Now’ Hints Fed May Soon Need to ‘Do Things Differently’
– Once Fed Reaches ‘Neutral,’ Next Rate Move Could Be Down
– Balance Sheet Shrinkage Being Rethought Given Reserve Needs
– Term Premium Explanation Of Yield Curve ‘Completely Empty’
Written exclusively for InTouch Capital Markets
Published 23rd July 2018 (based on an interview performed on Tuesday 17th July 2018)
By Steven K. Beckner
ST. LOUIS – Federal Reserve Chairman Jerome Powell famously said last week the Fed’s policymaking Federal Open Market Committee believes that “for now–the best way forward is to keep gradually raising the federal funds rate,” but he and the FOMC majority may get stiff resistance from some quarters.
One is the Federal Reserve Bank of St. Louis, whose top economist Christopher Waller argued strenuously against any further rate hikes in an exclusive interview last week. Not only is there no inflation or financial instability to preempt, but continuing to lift the funds rate practically guarantees an inverted yield curve unless long-term interest rates finally start rising, he said.
Such an inversion must be headed off, Waller argued, calling it “the canary in the coal mine” dependably foreshadowing recession. He vociferously disputed claims that low term premiums explain the yield curve’s current flatness.
It is the second time in recent weeks that a senior Fed official has raised warnings about continued rate hikes in interviews. In June Philadelphia Fed President Patrick Harker, who voted for all three 2017 rate hikes, told me the Fed should raise it only once more this year (not two as the FOMC majority plans), in large part to steer away from a yield curve inversion. “If we can avoid it, we should avoid it,” he said.
Could such rumblings, together with mounting concerns about how higher tariffs might affect economic and financial conditions, ultimately alter the funds rate trajectory?
It’s too early to say. As of June 13, when they revised their Summary of Economic Projections, a larger number of FOMC participants (seven) saw the need for two more rate hikes this year than believed one more would suffice (five officials).
But the realization that the funds rate is getting close to neutral and that short-term interest rates are rapidly narrowing the gap with stubbornly low long rates could well cause some rethinking of rate hikes.
Waller thinks Powell’s telling use of the phrase “for now” signifies the FOMC “might have to do things differently” before long. In fact, he said, once a “neutral” stance is reached, the Fed’s next rate move “could be down.”
There is also some rethinking going on about balance sheet policy, he says, as Fed officials reevaluate the appropriate size of reserves needed to meet federal bank regulations.
How trade negotiations with China, the European Union and others turn out could have an important bearing. Waller expressed concern about potentially adverse outcomes. As it is, trade uncertainty has caused “a lot of hesitation” on business investment, he told me on a visit to his office last Tuesday.
The Fed ‘Has Done Enough’
Waller, who as the St. Louis Fed’s executive vice president is President James Bullard’s top monetary policy advisor, was blunt-spoken on the need for great caution on raising rates from the current 1.75% to 2.0% target range.
Despite above trend GDP growth and tightening labor markets, he saw no sign inflation is going to persistently overshoot the Fed’s 2% target. That rate is “pretty stably built into expectations.”
At 4.0%, the unemployment rate is five tenths below the FOMC’s estimated longer run rate or NAIRU (the non-accelerating inflation rate of unemployment) as it’s sometimes called. And the FOMC projects it will fall to 3.5%. But Waller told me that “has nothing to do with inflation…it just measures market tightness and labor search.”
Rejecting the Phillips Curve theory on which the NAIRU concept is based, he said, “I think unemployment can stay at 4% for a long time, and you’re not going to see any big ramifications from it….The Phillips Curve says we should be blowing inflation out, but it isn’t doing anything.”
Since the FOMC left the zero lower bound in December 2015, it has raised the funds rate 175 basis points, and Waller said his Bank’s view is that “whatever we’ve done up until now, that’s enough. We’ve done the relevant tightening.”
“Inflation is basically at target; GDP is moving above target; unemployment is below target, so we’ve tightened up based on those two things, but all we need to,” he continued.
Waller, who frequently references 2019 voter Bullard’s philosophy, said their view is that “if you don’t see any longer term inflation…just let the economy go.”
More hawkish policymakers, such as erstwhile “dove” Boston Fed President Eric Rosengren, fear above-trend growth will tighten labor markets to the point that wage-price pressures accelerate.
But “we’re not seeing it,” Waller asserted. “So why do you want to raise unemployment and lower economic growth if there is no cause or benefit from doing it?”
What’s more, “there is no financial instability,” he went on. “So I think we’re at the point of not seeing any cost from this in terms of inflation. We’ve pretty much done this right.”
“If you think growth and unemployment are higher and lower than they need to be under the Phillips Curve you need to rethink what your benchmarks are,” he added, noting that even in the SEP, inflation is not projected to exceed 2.1% over the next three years.
The median FOMC projection is for the funds rate to rise to 3.4% by the end of 2020, compared to an estimated longer run neutral rate of 2.9%, but Waller said he and his boss think “we don’t need to go much higher” than 2%.
“Things may just settle in at these rates, and if growth stays high and unemployment stays low and inflation stays at 2%, what a great economy!” he said. “That’s the goldilocks (scenario). Open the champagne!”
Pressing the case against further tightening, Waller implored, “Look out and (ask) do I see inflation expectations unanchored? No. Do I see inflation accelerating and getting out of control? No. Do I see wage growth getting out of control? No.”
“What are you trying to head off?!” he asked. “There’s nothing in the data that suggest you need to ‘get ahead of the curve’ … We’ve done it. We got ahead of the curve. That’s why inflation is anchored at 2%. We did it through this series of rate hikes.”
Don’t Invert Yield Curve, Regardless Of Term Premiums
Waller warned that “to go much more is risky.” In particular “doing too much” tightening risks “inverting the yield curve.”
At the time of the interview, the 10-year Treasury note yield was 2.86%, compared to a two-year note rate of 2.60% — a spread of just 26 basis points, and Waller said this means “we’re only a move or two away from inverting the yield curve if the long end doesn’t move….If we hike two more times this year, you’ll have an inversion.”
Waller believes that could be disastrous: “it’s not causal, but every time this thing inverts, in large part because the short end is going up faster than the long end it’s been a beautiful predictor of recession…It’s kind of the canary in the coal mine. The canary dying isn’t causing problems ahead; the canary is telling you there are problems ahead.”
The shape of the yield curve reflects two factors, he argued:
* first, the market just has a very negative outlook on growth and productivity down the road. So that’s why the long end is low. They just don’t see good times ahead relative to the short run, and if people think things are going to be bad they make all kinds of decisions that are different than if they think things are going to be good. If the market thinks things are going to bad, it’s funny how suddenly you start taking actions that lead to the economy being bad. It’s a self-fulfilling prophecy almost.”
* second, “if we push up the short end and the long end doesn’t move we’re jacking up real rates. We’re jacking up real rates too much, and you’re effectively causing a slowdown in the economy that maybe isn’t warranted by a longer run view of the economy….”
Waller observed, “We got burned in 2000 and 2006. Why do we want to keep saying ‘this time is different’ and play with this fire again?”
“Why don’t we think about not raising rates so fast?” he asked. “It’s like ‘hike and be damned. Full speed ahead.'”
Powell and others have downplayed the significance of a flat to inverting yield curve, arguing among other things that long rates are being held down by low term premiums, a vestige of the large-scale bond buying or “quantitative easing” the Fed and other central banks did after the financial crisis.
But Waller called that argument “completely empty.”
“QE is over,” he declared. “it’s unwinding. All those things have to be built into prices. So what you’re seeing on the long end…. there’s nothing in there about risk aversion. This is just low economic performance in the future or a super high demand for safe assets around the world, which says global stuff is not good.”
“It really is astounding to me to sit there and watch us hike 175 basis points, and the long end has gone up 45 basis points,” Waller exclaimed. “I never would have believed this when we started hiking, that we would be this close to inversion.”
Labeling as “nonsense” arguments that low term premiums are holding down long rates, he said the real explanation is market expectations of “bad economic outcomes ahead — low productivity, low growth and bad world economic performance. That’s why everyone wants to hold safe assets.”
And now a potential trade war is darkening the horizon, he noted.
“So this idea that it’s okay to invert this time because of low term premiums, I don’t know….,” he said. “If you jack the short-term rate too much you invert… Real rates are too high. I don’t care what the term premium is.”
Waller recalled that in 2006 people were also saying “it’s different this time” because of a “global savings glut” caused by China.
“Why do we keep playing it?” he asked. “What’s the point?”
“If we saw inflation expectations now at 2.5% to 3%, Jim and I would be singing a different story, but we just don’t see the inflation; It’s not in the data. It’s not in wage growth. We’re not seeing it anywhere. So if you’re telling me we have to jack up rates to raise unemployment and slow down growth, it doesn’t sound very good. People are going to ask: why are you doing that?”
Waller said part of the FOMC majority’s tightening reflex stems from “a general sense among a lot of people who just want to get back to normal. ‘It’s been 10 years, let’s just get back to normal.’”
“But what is normal?” he asked. “Maybe the last 10 years is telling them the old normal is gone.”
Only Two More Hikes To Neutral
Many Fed officials have wanted to get the funds rate as far above zero as possible to give the Fed leeway to ease if needed, but Waller countered, “that goes back to what is the real neutral rate.”
The FOMC has steadily lowered its estimate of the longer run funds rate, but at 2.9%, including the 2% inflation target, that still implies a real rate of nearly 1%. In reality, Waller maintained, the real neutral rate (r*) is “near zero” or at most 0.5%, implying a neutral nominal funds rate of no more than 2.5% and probably closer to 2.25%.
Given those assumptions, “if you want to get back to neutral, you only have two more hikes,” said Waller.
With 2% the upper end of the funds rate target range presently, monetary policy is “a little accommodative, but not much,” he continued, adding, “we don’t see any reason to go” to a neutral, much less restrictive, stance.
“Whatever we’ve done in the last year is enough; we don’t need to do anymore,” he declared.
Some, such as Kansas City Fed President Esther George, argue that, even if inflation is low rates need to rise to guard against financial excesses and imbalances, but Waller said, “we don’t see anything that looks like financial excess. We don’t see booming (markets) or very high leverage…All this stuff we saw last time is not there.”
Even the stock market has been “pretty much flat” over the past six months, he contended. He said he is “a little concerned” about the housing market, but said the run-up in home prices is largely due to a shortage of houses, not excessive credit.
“For Now” — “Doing Things Differently”
The FOMC streamlined its policy statement in June, notably deleting the previous “forward guidance” that “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” And Waller said the FOMC is not done tweaking its communications.
Before long, the FOMC will have to stop saying policy “remains accommodative” after each rate hike, he said.
“If people think neutral is 2.75%, two more hikes by the end of this year we’re not accommodative anymore,” he explained. “So that language can’t be there anymore if you’re going to do more hikes by the end of the year because you’re pretty close to neutral.”
As for Powell’s qualifier “for now” regarding further “gradual” rate hikes, Waller said his interpretation is that “we’re getting to a situation where we might have to do things differently.”
Indeed, he said, “it could get to the point where we might have to think about lowering rates.”
“He didn’t say anything like that, but when you get to neutral you’re in a situation where your next move could be back down, not up,” Waller elaborated. “That’s the whole point of being at neutral and you start reacting to the economy. Your next move might be back down, not up.”
In any case, as you get closer to neutral (the word accommodative) has got to come out. ….It’s not an accurate description.
Rethinking The Balance Sheet, Reserves
The Fed has been reducing its bond portfolio steadily and predictably according to a schedule announced a year ago and implemented last September. The Fed hasn’t said when it will halt the unwinding, but Waller said there is increasing talk of curtailing the shrinkage to maintain a much larger balance sheet than before the crisis, largely for operational reasons.
“There is suddenly this discussion about…everybody thought that $2 trillion or $1 1/2 trillion of reserves was plenty,” he said. “But now when you’re looking at the federal funds rate and you’re starting to see a trickle above or at the funds rate (target) people think maybe it’s not as flush…”
“Banks are happy to use reserves for liquidity coverage ratios and all the sort of things that were never there in the old days…,” he continued. “There’s starting to be some discussion that maybe our balance sheet may have to be bigger than we ever thought it was going to be for these regulatory reasons that have come on.”
“I don’t know the answer, but I know there’s starting to be discussion about, ‘man, how many reserves do we need to have in the system? They’re not required, but banks like to have them for liquidity coverage ratios.”
Now if you got rid of liquidity coverage ratios then you’ve got plenty of reserves in the system. But that would be the debate: given the regulatory changes and how reserves are viewed by the banks and regulators, going back to a very small amount of excess reserves in the system may not be (feasible).”
Heightened Uncertainty About Trade
Powell was circumspect about trade tensions, telling the Senate Banking Committee he preferred to “stay in his lane” and not prejudge the outcome of trade talks, but he did allow that higher tariffs could be damaging.
Waller was less bashful in agreement. He acknowledged it’s not easy to forecast the overall impact of higher tariffs on foreign goods and of other nations’ retaliatory tariffs on U.S. products. Strictly as a mathematical matter, if imports fall as much as exports, he said GDP growth may not change much at all.
But he warned of huge “redistribution” effects. He cited how steel and aluminum tariffs are affecting different firms in the St. Louis Fed’s diverse eighth district.
“We have some steel and aluminum producers in our district,” he noted. “They’re expanding employment due to the steel and aluminum tariffs. We have a bunch of firms that use steel and aluminum and they’re laying off workers.”
“So one group of people who produce steel are expanding,” while “those who use it are contracting,” he continued. “I don’t know why you want to do that labor redistribution.”
Waller said “it’s not clear there is going to be a big net job loss from this,” although he added “if you got into some full-blown global trade war then all bets are off.” “But prices for sure are going to go up,” Waller warned, pointing to sharp increases in prices of steel since tariffs were increased.
He was careful to add that “temporary” price increases in individual products won’t cause an overall inflation surge because they reduce consumers’ wherewithal to buy other goods and services.
Referring to possible increases in auto prices due to the higher cost of steel, Waller said, “the question is: can they pass through these costs increases or not? When you have this happen either a firm’s profit takes a hit; workers take lower wages or you reduce input costs somewhere else, or you pass it along to customers.”
“So tariffs are the equivalent of taxes.”
Waller said the unresolved tariff war is already hurting business investment, a component of GDP which the Fed had been counting on to increase and fuel stronger productivity and wage growth.
“We’re getting a lot of comments from contacts in the district and other districts about the uncertainty about tariffs….,” he said. “We’re hearing about businesses postponing investment decisions … You’re not going to locate a plant somewhere and suddenly through some deal it’s now the worst palace to put the plant.”
“So there seems to be a lot of hesitation now on fixed investment,” he continued. “You may see this show up in the third quarter or fourth quarter. So if that were the case it’s obviously going to be a drag…”
What, if any, monetary implications are there?
“These would all be transitory kinds of effects… when you see jumps in prices,” Waller replied. “Now, if people start expecting an escalation of this stuff…, if they start building in expectations that these things are going to get worse, then temporary short-term things can be problematic” and “disruptive.”
For example, a firm “may permanently lose market share,” he said. “If you have to raise prices, customers go somewhere else, and when they go away they don’t come back.” Or, “you may relocate production and you don’t necessarily relocate back when the tariff goes away.”
As for monetary policy, he said, “if you were thinking about it from the Fed’s point of view and you thought these tariffs were going to have transitory effects on prices, then you would overshoot your (inflation) target for some period of time, but then you would expect it to come back down.”