Is the Fed Repeating the 2005 Mistake?

Look at this graph:

The red line is what the Fed actually did, and the blue line is what the Taylor Rule “suggests” for the policy rate. When the red line is above the blue line, Fed policy was “tighter than Taylor Rule” and same logic on the other side.

This is NOT a “hard rule” that central banks should follow blindly, as the context needs a lot of case-by-case analysis and expert judgement.

The “Taylor Rule” rate gives a qualitative approximation of policy stance by combining 3 things into one “policy rate” for a central bank:

  1. The “neutral rate”, which is the policy rate that you would expect if the economy was chugging along normally, at roughly full employment (around 4% or 4.5% for the USA) and “normal” inflation (around 2% year-on-year inflation for the core PCE price index). The neutral rate is considered to be a policy rate that neither accelerates nor slows down the economy. It is influenced by a few factors, but broadly speaking by 2 factors: 1) the global interest rate, which is determined by global savings, global liquidity conditions, and global demand for financing; 2) inflation expectations, which hovers around 2% for the USA and Canada.
  2. Inflation relative to the 2% target. When inflation is “above target” OR risks busting above target in the 1 or 2-year outlook, the policy rate would be higher because the central bank would want to slow down the rate of credit creation (with higher interest rates) so that inflation is kept under control over the medium run, such as 2–4 years.
  3. Job market conditions: a booming labor market with already-low unemployment would push the central bank to increase its policy rate due to future wage and price pressures feeding inflation.

From 2001 to 2006, the Fed’s policy stance was rather expansionary, keeping interest rates relatively low, as can be seen by comparing the Taylor Rule suggested rate to the actual policy rate of the Fed, which actually diverged in 2002, 2003, and 2004, with the Fed cutting rates, while the Taylor Rule suggested increases.

Some say that this “loose credit policy” was a contributing factor in the excessive credit expansion of 2002–2008.

At the same time, the Fed quickly increased the rate starting in 2005 due to a run-up of inflation that caused the Fed to start feeling “behind the curve” in the cycle and wanting to “catch up” with a more neutral stance, hence the quick policy tightening of 2005–2006 due to low unemployment and increasing inflation, which hovered above target starting in 2004…


Unemployment rate:

Employment rate of 25–54 years olds:

Some say the Fed is repeating the policy error of over-tightening with a trio that could hit banks and large institutions in 2018–2019 and increase the risk of recession: 1) increasing interest rates; 2) lower liquidity caused by “quantitative tightening”; 3) Macro prudential rules of Basel regulation forcing financial institutions to boost their capital cushion and liquidity provisions.

Understanding Central Bank Policy

Most people have no idea of the complexity of interest rate policy and monetary policy in general. A central bank must decide on the PATH OF RATES and the PATH for asset purchases and balance sheet expansion / contraction BEFORE knowing what will happen OR even what will be the impact of the chosen policy path, and all this must be communicated. This policy effect has impacts over a decade or more on all markets and countries: bonds, stocks, currencies, trade, labor, profits, debt and credit, etc.

What WOULD HAVE BEEN the job market, stock market, and other macro conditions if the Fed had increased its rate by, say, 0.5 percentage points per year since 2014? If it had not moved at all?

We are not totally in the dark on these things, because central banks use statistical models to at least estimate the impacts of potential policy paths. Now the Fed can choose many approaches to its policy path. Here are examples, with accompanying potential pros and cons:

Scenario 1: keep Fed Funds Rate unchanged for another year and don’t touch the balance sheet. The pros are that this would contribute to some “overheating” of the US economy, thus perhaps bringing down the unemployment rate down even more and boosting the currently-below-target-inflation. The con is a potential overheating in 2018–2019 and a need for a relatively fast policy tightening, which could destabilize markets and cause an unwanted recession or crash or both.

Scenario 2: increase rates quickly now to avoid being stuck with inflation and a destabilizing policy tightening in 2018–2019. The pro is that you would avoid the potential overheating… the con is that you might cause a recession due to excessive policy tightening now!

Scenario 3: increase rates gradually until the “neutral rate” is reached (which seems to be around 2%). The pro is that you avoid overheating, you avoid over zealous tightening, you avoid excessive financial bets with loose credit, and you keep the economy running at good and sustainable speed, without inflation and without a risk of a policy-induced recession or market panic caused by perceptions of the Fed “being behind the curve.” The con is… well I don’t really see one… and neither do Fed policymakers, which explains that this is the chosen approach!

A central bank has many policy tools at its disposal, but they boil down to 3:

  1. Short-term interest rates.
  2. Balance sheet (asset purchases and sales: bonds and currencies, etc).
  3. Communications.

I will not delve into these 3 categories of central bank interventions, but I want to mention that the most sophisticated and complex tool is communications, which also happens to be the less understood by market participants.

In any scenario a central bank chooses to embark, there are risks. One important policy risk is expectations and interpretations of market participants that can cause destabilizing moves in some markets.

For example, a central bank may “suggest” (via communications) that keeping interest rates low is “fine for now” etc (a “dovish talk”) and the market could start expecting future overheating, which would cause a drop in 10-year bond prices and a RISE long term yields and interest rates, thus maybe adding a drag on the short run outlook, while the central bank wants to keep policy accommodative.

The complexity and refinement of the impacts of communications are far-reaching and important to understand by financial analysts and market participants, because they give a clue into what is the probable policy path going forward and what could change. Communications have an impact on the yield curve and currency prices, as well as all market rates.

Quantitative tightening

Now the Fed is talking about reducing its balance sheet. What is that exactly and why is this a discussion right now?

The balance sheet of a central bank can be used to support financial asset prices (especially bonds and currencies), which in turn influence bond yields and other credit market interest rates and asset returns, from stocks to bonds to housing, and the balance sheets of financial institutions via asset value effects and in-out income flows (that finance and econ students study with “Duration Gap Analysis” and other frameworks that I teach them in my courses!). It also influences “yield spreads” (differences of yields between different asset categories and countries), which also impact credit and liquidity conditions for banks, multinationals, consumers, and governments.

When a central bank wants to slow down credit and money creation to avoid inflation and credit bubbles, it sells assets of its balance sheet: this causes an increase in market asset supply: prices tend to drop, yields tend to rise, and there is less liquidity available in the overall financial market. This is “quantitative tightening” and is equivalent to gradual interest rate increases.

Is there a hurry to tighten credit conditions in the USA? Well. Based on inflation: no. It is below target and is pointing down. See chart above.

Credit? Here is the ratio of non-financial private credit relative to nominal GDP for the last 10 years:

No credit bubble here! The ratio is even dropping since late 2016!

Maybe bank credit? Here is private credit by banks relative to GDP for 2004–2014 (and nothing suggests a major run-up since then):

Government debt is a non issue in the short run. The US government still has bomb-proof credit rating and plenty of breathing room for debt (even if actual debt is a bit high)…

So. No credit bubble. No inflation. No unemployment. No problem!

The Fed’s talk of reducing the balance sheet is there to signal to the market that this will happen GRADUALLY and may be halted and re-expanded at the first sign of disinflation and slowing. It has no real punch and Yellen’s Fed will not continue on a path of “quantitative tightening” if it sees signs of slowing growth and inflation.

So why are they going ahead now with gradual interest rate increases and balance sheet reduction (quantitative tightening)? Because the Fed estimates that the soft data of 2017Q1 was a temporary “soft patch” in an otherwise normal expansion. They do NOT expect continued weakness and low inflation, which explains they are relatively confident about a gradual and slow “normalization” of policy, which consists of 1) bringing the Fed rate towards the neutral rate of approximately 2% by end of 2018 and 2) slowly bringing the balance sheet back to normal.

My 2 cents: the Fed rate may gradually increase its policy rate, but the lack of inflation and the “soft patch” may prove a bit longer than they expect, and the balance sheet policy will probably be watered down soon, thus adding depreciation pressure to the usd, because the little usd “bullishness” that was priced in recently will fade fast — follow the COT report to see where the market timing sits ;)

The low unemployment rate without inflation context is the direct result of automation, globalization, and efficiency. On top of that you have high income inequality, which generally weighs down on aggregate demand and downward pressure on oil and commodity prices:

In my humble opinion, there is no overheating in the US economy and the Fed is underestimating the slack remaining in the labor market as well as the lack of inflation. We can run ahead for another 2 years without significant danger to price stability, as long as the policy rate is gradually normalized. The balance sheet can wait.

So is the Fed making an error? No. I do not think so, because FOMC members fully understand all that is written here and more, and they made clear to the market that the balance sheet normalization will be very slow and gradual, to a point of not being felt… and they stand ready to stop the balance sheet normalization and even re-expand it as needed.

They are doing all this just to add some breathing room for future policy moves that would be needed in the face of adverse shocks and to signal to the market that they are still “on top of inflation” to avoid a de-anchoring of inflation expectations due to the low unemployment context. They are not tightening policy in any significant way, and they don’t aim to. Please take 3 seconds to click the “like” (heart) if you appreciated the free insights. Thanks for the read.

Pascal Bedard