Written exclusively for InTouch Capital Markets
12th October 2018
By Steven K. Beckner
Has the Federal Reserve “gone crazy,” as President Trump alleged in the midst of an 832-point drop in the Dow Jones Industrial Average and an even bigger percentage drop in the Nasdaq Composite? What is it really up to?
One reason for the recent market selloff, no doubt, is fear that the Fed will go right on raising interest rates indefinitely until it breaks the back of the expansion out of some misguided determination to avert inflationary “overheating” and/or financial “imbalances.” The belated response of long-term rates to short-term hate hikes has reinforced such worries.
But that is not the Fed’s intention. Quite the contrary, as Chairman Jerome Powell tried to make clear after the Federal Open Market Committee raised the federal funds rate for the third time this year on Sept. 26, and as other sources have told me.
Nor is the Fed motivated by a desire to get the federal funds rate as far away from the zero lower bound as possible, I’m told.
While a policy mistake — going a bit too far with policy firming — is always possible, as officials acknowledge, the Fed’s aim is to support expansion in pursuit of its dual mandate as long as possible — not interrupt it.
The upper limit of the funds rate is not some preconceived level of restraint, but whatever rate is deemed to comport with its best estimate of neutrality, which Powell recently defined as “where the rate should settle at when policy is neither expansionary nor contractionary.”
Let’s examine what Powell and his FOMC colleagues are trying to accomplish.
Looking back, when the Fed was still holding the funds rate near zero for a seventh straight year going into its December 2015 FOMC meeting, then-Chair Janet Yellen and her colleagues had finally come to believe the economy had recovered sufficiently from the financial crisis and recession to be able to absorb some monetary “normalization.”
But that wasn’t the only motivation. As Fed officials told me then, another consideration in deciding finally to “lift off” from the zero lower bound was a desire to put as much distance as possible between the funds rate setting and the zero lower bound to give the Fed a counter-cyclical “cushion” — to give itself room to cut rates to fight a potential recurring recession and/or deflation without having to resort again to “unconventional” easing that would balloon an already bloated balance sheet.
A big reason the Fed waited until October 2017 to start reducing the $4.5 trillion balance sheet it had built up through three rounds of quantitative easing (actively preventing any shrinkage by continuing full reinvestments and rollovers of maturing securities) was because they preferred to focus on getting the funds rate off the floor to enable rate cuts if needed.
One might suspect that, as it projects further “gradual” rate hikes, the FOMC remains motivated by a desire to get further away from what is now called the “effective lower bound” (ELB) to give itself leeway to ease without having to resort again to Q.E.
But I am told that is not the case.
To be sure, officials do express wariness about the funds rate target’s proximity to zero.
Chicago Fed President Charles Evans, who advocates making policy “mildly restrictive,” warned in mid-September the lower level of the “neutral” funds rate “means we don’t have the same capacity to cut interest rates in response to adverse economic shocks as we did in the past. And if we run out of such room, then we may again have to turn to unconventional tools such as large-scale asset purchases and forward guidance about the funds rate to provide monetary accommodation….
Recalling that the Fed typically cut the funds rate about 500 basis points in recent decades to mitigate downturns, Evans warned, “Today, given a neutral federal funds rate in the range of, say, 2-1/2 to 3 percent, we simply do not have that kind of rate-cutting capacity. So, unfortunately, the risks of returning to the ELB are higher than we would like.”
Research has variously put the odds of a recession at any given time at 15% to 40%.
At the July 31 – Aug. 1 FOMC meeting, minutes reveal the Fed staff briefed policymakers on “the extent to which some of the Committee’s monetary policy tools could provide adequate policy accommodation if, in future economic downturns, the policy rate were again to become constrained by the effective lower bound (ELB).”
The staff saw “a meaningful risk that the ELB could bind sometime during the next decade,” forcing a return to Q.E. and forward guidance. They warned “the effectiveness of monetary policy in general, including forward-guidance and balance sheet policies, was limited in mitigating the initial downturn in the economy….”
In the ensuing discussion, FOMC participants “generally agreed that their current toolkit could provide significant accommodation but expressed concern about the potential limits on policy effectiveness stemming from the ELB.” And they “viewed it as a matter of prudent planning to evaluate potential policy options in advance of such ELB events.”
But are FOMC rate hikes currently being driven by a desire to give itself extra margin to cut rates to stay away from the ELB?
According to sources integrally involved in the normalization process, that is not the FOMC’s primary motivation. Rather, it is overwhelmingly motivated by traditional economic concerns.
Creating a rate cushion is “not at all” why the FOMC is lifting rates, said one. “None of our models work that way.”
Rather, “the idea is to set the funds rate in coming quarters at the rate the economy needs to stay on track without inflation accelerating or decelerating…,” the source continued. “The premise is that without rate hikes, inflation would likely accelerate.”
“That can be thought of as the Phillips curve reasserting itself, but that’s sort of tautological, because unemployment is so low,” he added. Powell has said much the same in his own way.
Even if cushion-building is not the objective, that may be the practical effect. Two birds can be killed with one stone. While there is little appetite to make policy as restrictive as it’s become in previous recoveries, the economy’s above trend growth and tightening labor markets give the Fed justification to move further away from zero.
At the same time seemingly controlled inflation and well-anchored inflation expectations limit the need to tighten aggressively, reinforcing the gradual normalization strategy and enabling the expansion to continue and avoid a return to the zero lower bound.
One of the biggest uncertainties facing the Fed is just where neutral lies. Powell put it “somewhere in the range of 2-3/4 to 3 percent.”
With the FOMC’s eighth rate hike since 2015, the funds rate is in a target range of 2 to 2 1/4 percent — below Powell’s estimated neutral range. The reiterated projection is for the funds rate to reach a median 3.4% by the end of 2020. That would be modestly restrictive.
The Fed’s understanding of neutrality continues to evolve with economic forces. FOMC participants elevated their estimate of the longer run funds rate a tenth to 3.0% last month. That’s still 125 basis points below where it was believed to be just six years ago, but when I asked him about it Powell expressed hope it will rebound further in coming years due to improved productivity growth and other factors.
The Fed’s chief aim, Powell made clear, is to give the economy adequate support. Unlike some of his fellow policymakers, Powell has not made up his mind that policy needs to become restrictive.
“What we’re going to be doing as we … go through time is asking at every meeting whether monetary policy is set to achieve our goals,” he told reporters after the last FOMC meeting, “And I think that that’s an assessment of where policy will need to be some years down the road…”
As he has said numerous times since becoming chairman, Powell said the Fed may have to raise rates either more quickly or more slowly depending on the pace of inflation, GDP growth and so forth. He wants to “balance” the two risks.
Pressed on whether monetary policy will be made restrictive, Powell replied, “It’s possible. It’s very possible. It happens often….”
But, he added, “ultimately, that isn’t really the question we’re answering. The question we’re answering is, how do we provide the economy just the right amount of support — not too much, not too little — to sustain the recovery and achieve our statutory goals?”
As Milton Friedman once said, monetary policy operates with “long and variable lags,” but by moving gradually, Powell and Co. hope to be able to accurately calibrate how much accommodation the economy needs and avoid either overdoing it or under-doing it.
If that gives it more headroom, so much the better, but that’s not the goal.