I’ve got two objectives here. One is to talk about the Fed and the other is to discuss the evolution of the US economy. Most of what I want to say is upbeat, both on the Fed and the economy. And I’ll lead with that. I do have some doubts about the long-term though – and I want to give voice to that too, especially in view of comments suggesting the Fed is targeting overheated asset prices.
OK, let’s lead with the Fed. To put it succinctly, I think the Yellen Fed has done as good a job as could have been expected, doing a high-wire balancing act as it is assailed by hawks and doves with very different views of where policy should be,
Let’s remember that we were on zero – what I was calling permanent zero in reference to Japan’s near permanent rate policy – for something like seven years. That’s extraordinary.
Bernanke started the tightening by winding down QE and handed the Baton over to Yellen. Yellen took us off zero and has now raised rates four times. Soon she will start rolling off the balance sheet.
Be honest, this is a more aggressive tightening than you expected. I still see a lot of hawks railing against the Fed and easy money even now despite policy rates higher than developed economies anywhere this side of Australia and New Zealand. That includes the UK, Canada, the eurozone, Japan, Switzerland, Sweden, Denmark, and Norway.
Now the Fed is being assailed for being too aggressive. Hence the letter on raising the inflation target signed by economic gurus like Dean Baker, Brad Delong, David Blanchflower and Joseph Stiglitz.
This is where the economy comes into play.
Take a look at what I was saying about 2016 and the outlook for 2017:
“The year  started off in a gloomy way. The data were middling to poor, risk assets were selling off and government bond yields were nose-diving as if there could be a recession at some point in the year. I went on recession watch. Mind you – my mantra has been that the data never indicated a recession was coming. But the inventory purge and the investment downturn were significant enough to show a sharp deceleration in non-farm payrolls growth and to cause rolling trend GDP growth to decelerate. In a nutshell, US trend growth was slowing so much that we couldn’t rule out a recession – and should have been actively prepared if one came.
“But I think that’s over now. I am not on recession watch right now. We are seeing a re-acceleration of growth, against a backdrop in which both the inventory purge and the capex shortfalls have gone away. Oil prices have stabilized – and that takes a lot of tail risk from that sector off the table. In short, we are still in a sort of muddle through scenario of 2%ish growth – but now the risk is to the upside instead of the downside. This is an environment in which the Fed can hike rates without the domestic economy getting crushed. And I believe we should expect several interest rate hikes in 2017 as a baseline scenario as a result.”
And voila, we’ve got exactly what we expected!
So far, so good. But the long term outlook is still weaker in my view. And I have written a lot about my concerns there recently. And I will get back to them.
First, I want to flag another concern: financial stability.
Now, the way Neel Kashkari put it a few of months ago suggested that financial stability is a core function of the Fed’s role as regulator, but not a driver of policy. But even then, some private sector economists felt that easy financial conditions were actually the marginal factor driving hikes. Now, the Wall Street Journal is also reporting that financial stability worries are driving hikes.
Years of easy-money policies by the Federal Reserve have powered the U.S. stock market. Now, Fed officials say they are watching closely for signs that those policies are prompting risky market wagers.
A series of speeches from Fed officials Tuesday indicated a wariness about asset bubbles and hinted that the Fed may tighten monetary conditions even if key economic signals remain subdued.
As The Wall Street Journal’s Morning MoneyBeat newsletter noted, the notion that central bankers will be quick to support markets to help achieve stable prices and full employment has been validated many times since the financial crisis, but it may lose sway should Fed officials see rising bubble risks.
In remarks prepared for delivery at an International Monetary Fund conference, Federal Reserve Vice Chairman Stanley Fischer pointed to rising stock valuations, thin corporate bond spreads and ultra-low readings on the CBOE Volatility Index as signs of increased risk-taking. While such rising prices have yet to inspire extreme leverage, he said, valuations bear monitoring.
Fed Chairwoman Janet Yellen said in a separate speech that asset valuations were “somewhat rich.” San Francisco Federal Reserve Bank President John Williams told the Australian news media that there are signs of “some, maybe, excess risk-taking in the financial system with very low rates.”
But is hiking rates the best way to go about addressing these concerns?
We’ve been here before. Greenspan’s conundrum at the tail end of the housing bubble was that long-term rates were not responsive to Fed hikes. And eventually his Fed hiked so much the yield curve inverted and we ended up with a mother of a financial crisis.
Fast forward to now and Janet Yellen is saying we shouldn’t expect another financial crisis in our lifetimes. Maybe she’s thinking that banks have finally received the all clear on the Fed’s stress tests. And so our financial system is stronger. But yield curve flattening is telling us something ominous.
Here’s my narrative:
- Too much emphasis is placed on monetary policy. After 2009, it was the only game in town. In fact, fiscal policy in the US was the tightest of a bunch of countries that Martin Wolf looked at.
- This monetary-policy-uber-alles paradigm led monetary policy to being too tight for the real economy but too loose for the financial economy. Zero rates certainly helped to spawn the shale oil bubble, the commercial real estate boom and the subprime auto boom. But in the real economy, we have been treading a 2% growth line and the gap between the broadest measure of unemployment and the headline rate has yet to close.
- Now that the Yellen Fed has decided to tighten, it finds itself in the same unenviable position Greenspan Fed was in, with long-term rates unresponsive to tightening amid signs of financial excess.
- If the Fed thinks that tightening in large part due to financial stability concerns will work despite inflation below target, it should remember the violent reaction of 2007 to 2009 after the yield curve first inverted in 2005.
My view: I think the die is cast here. The froth that the Fed is concerned about actually came about because the over-reliance on monetary policy caused financial assets to appreciate well before the real economy was healed. Bernanke and Yellen both complained repeatedly about this in Congressional testimony, but felt bound by the Fed’s mandate to use monetary easing even so.
But now that we are on the tightening side of things, the Fed should not use rate policy to deal with financial stability concerns. Instead the Fed should act in concert with other regulators to use non-rate mechanisms to exert regulatory control over arenas where they feel financial stability is a problem. The Fed should concentrate rate policy on its dual mandate and that’s it.
The worst case scenario here is a repeat of Greenspan’s conundrum leading to curve inversion. And contrary to Yellen’s view, the risk of crisis is still there, especially in an economy that has long term growth problems and less policy space. I suspect the Fed is aware of the risks. But it is still marching down the same path.