Tuesday, October 25, 2016

Fed rate hikes matter

Fed rate hikes matter

There are two extreme schools of thought on the Fed. One is that because of the size of its balance sheet it controls everything: the level of interest, the yield curve, all of it. Another view is that the Fed does not matter because the market still can poke through the veil of secrecy and get rates where it wants them. If the Fed has a different view from the market and it lower rates too much the market will steepen the yield curve. If the Fed over tightens, the yield curve inverts to compensate.

Reality- Between these two extremes there is the reality which I believe is that the Fed sets the short rate and influences the long rates – how much influence remains a matter of debate. But I do not think that the Fed pegs all rates yet it does disrupt many of them in a way that may render the yield curve and the rate spreads as much less useful barometers on the markets and on the economy compared to more ‘normal’ times. Markets can be fooled by what the Fed does and says and markets can be misled as well.  

Mystifying monetary policy- With the economy fragile, growing slowly, productivity weak, inflation still undershooting and the outlook uncertain, it would not be a good time for the Fed to mystify markets but that is what it seems to be headed for.

The WSJ view as an example of what is wrong- A recent WSJ article (here) just jumbled together the ideas of the Fed guiding markets, communicating clearly, and having made up its mind about December while fluffing past the notion of the Fed being data-dependent. 

Two schools on the Fed- Interestingly a number of Fed critics think that the Fed is doing the economy a disservice by keeping rates so low. Another group fears that the Fed is ready hike them too soon or too quickly or by too-much altogether. I am in that latter group.   

The 2015 paradigm- In my view, the Fed got itself into trouble in 2016 by what it did at the end of 2015- hiking rates prematurely.  Amid great fanfare, calling the period of special accommodation over, the Fed raised rates in December about 10-months ago even though its own stipulations for a rate hike had not been met. But since many (all!) Fed officials had said at one time or another last year that they expected to raise rates in 2015, the Fed felt obligated to do just that – even though to do it required that the Fed violate its own rules. To accommodate and justify that rate hike that the Fed claimed to make policy based on its view of the intermediate term and where it ‘deemed’ growth, inflation rates and unemployment were going. That is how, with oil prices in the midst of spiraling lower and lower, the Fed was still able to move to hike rates in December of 2015. That is something that will always look like a really foolish mystery to future Fed historians. How could the Fed think it was on path to meet its inflation objective with oil prices in near freefall?  

The 2016 question: Now what is the Fed going to use to justify a rate hike in December 2016? It will pass on a rate hike in November because of the elections but will state a different reason. That is allowable central bank misdirection. But (a) with growth still weak, (b) inflation under shooting - (c) not accelerating- and with (d) the unemployment rate having stopped its relentless move lower and (e) having backed up from its lows, what will be the Fed’s excuse/reason for hiking rates this time?  

And why does it make a difference?

Why rate hikes make a difference
International fragility and feedback- While the Fed has from time to time talked about the importance of the international economy and on two occasions in the past year actually swerved policy (allegedly) for international reasons, the Fed’s expressed view of the importance of the international economy misses the point. The point is not that international turbulence should stay the Fed’s hand (Sept of 2015 and early 2016). Nor is the point that Brexit was a risk and a reason for policy to hit the pause button. Not that I am not arguing that those decisions were wrong, just that they miss the point. Yellen has talked of how monetary policies are more connected in some way which is curious because under floating rates monetary policies are supposed to be more independent. But that is getting somewhat closer to the point.  

Structure, impact and policy diffusion- There are several aspects on internationalization that the Fed seems to almost completely ignore. The first (1) is the way in which trade already had changed the structure of the U.S. economy and made it more vulnerable. The strong dollar already makes it hard for the U.S. to produce anything at home for export or even in competition with imports. Technology should be an equal opportunity disruptor but it has disrupted the U.S. more because of its high wages and uncompetitive exchange rate. A Fed rate hike (2) will make all that worse by moving the dollar higher, making it even less competitive. But that is not all it will do, (3) a stronger dollar will drive up the foreign currency cost of all commodities, oil included, and that puts downward pressure on dollar prices. A strong dollar will spread the U.S. rate hike globally; it is globally deflationary at a time that other central banks are trying to jump start inflation. Is that a good idea?  In summary, I am concerned not so much about the Fed hiking rates and about that impact on the US economy as I am concerned about the feedback effects in the international community

And it is  NEVER about just one 25bp rate hike-. However, do not dismiss the prospect of a Fed rate hikes as unimportant at home. Many have asked, “what’s the trouble with one 25bp rate hike?” Well that was December 2015 and you tell me, “what followed?” It was one 25bp rate hike… followed by chaos. Some of that chaos was Fed-generated as Stanley Fischer came forth with his great theory of why the markets were wrong and what the Fed would really do. Stanley will still be eating crow for Thanksgiving this year (…with a wonderful dessert of humble pie) he has so much stocked in his refrigerator after that dead wrong analysis- road-kill crow.

Fed fears make for bad policy moves- And that is just another reason why we should be wary of Fed policy pronouncements or forward guidance: the Fed simply is making it up as it goes along. It has little wisdom to impart, and worse, members have an agenda. They now fear anything from inflation to bubbles. They are not sure which is worse but they are sure that this will end badly and that there is something to fear and nothing like slamming policy into reverse to fix it.  

Not Ptolemy Copernicus or Kepler: the Big Bang radiates! -  Rates are important. Interest rates sit at the center of the international economy’s perceptions. They impact exchange rates. They are links to current and future consumption and investment. They have a role is setting inflation expectations. This is the last place that the Fed needs to be spreading mischief. If it is appropriate for the U.S. to raise rates it should be sure – very sure- because there will be repercussions of a significant nature from abroad, too. Last year’s hike should have made that clear. But I get the sense that the Fed has not learned much from that episode and instead treats it like a one-off event instead of like the endogenous response to the Fed’s own actions that it was.   

A mind is a terrible thing to waste…a waist is a terrible thing to mind…In short I fear that the Fed has grown and learned very little. It still seems to regard its new tool box as adequate, or it is willing to act as though it does. It seems to be willing to be bold with policy and inventive with its forecasts despite the economy’s circumstances and its past lack of forecast ‘suck-cess.’ In the guise of lifting rates to get away from the zero bound threat the Fed is flirting with that very problem and may force us to deal with it very soon instead of just to think about it hypothetically. Rate hikes are important because they are dangerous. Play with fire at your own risk. Ask yourself this…if there were no Fed what would the markets be doing with rates in this environment?  I don’t think that marching higher is a likely result. Do you?         

General central banking rules-  

My bottom line is that the central bank should have reasons for what it does. It should make these reasons known and be true to them. If it expresses a model or point of view its policy enactments need to be consistent with that view. Central bank policy should not cram the square peg of policy change into the round hole of what I said I’d do. Policy should be easy to understand and should not take much hairsplitting to explain why the bank acted as it did. Policies should flow freely out of the central bank’s policy ‘map’. No right hand turns from the left hand lane.     

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