The succession battle at the Fed and the Fed’s reaction function

Long-term interest rates are largely a reflection of expected future short-term future interest rates plus a term premium. So when you see yields move up, it reflects either an increase in term premiums from uncertainty or a change in the consensus view of the expected future path of policy rates. This means that rates are anchored by present rates, inflation expectations and the Fed’s reaction function. The Fed’s reaction function is the key variable here as the other two aspects are known quantities.

I apologize for not writing for a few days but my wife is in Peru for two weeks and that leaves me fill

ing the void with a lot less time for the site. I had expected write a decent amount because, despite the summer holidays, there is a lot to say, particularly when it comes to technology, media and telecom. But this post is going to be a brief one on the Fed.

Yesterday, I saw three Fed Presidents, Fisher, Plosser and Evans, talking up a September taper. In conjunction with what we know about Elizabeth George out of Kansas City, it suggests that the taper is going to happen in September. And Paul Volcker recently weighed in saying that QE was bad policy. So that’s a big vote against from a moral suasion point of view. In addition, Morning Money (M.M.) today’s Politico morning email commentary led with a piece labelled “Could Fed Fight Be Biggest D.C. Risk?”

M.M. sat down with Goldman Sachs chief economist Jan Hatzius on Tuesday in his office at 200 West Street overlooking the Hudson River and New York Harbor in Lower Manhattan. Hatzius is generally optimistic about the trajectory of the U.S. economy, expecting upward revisions to Q2 GDP and growth of around 3 percent next year as the fiscal drag starts to come off and hiring picks up at least a little. He ranks D.C. dysfunction as number two on his list of risks to the U.S. economy (behind a bungled Fed exit from quantitative easing). But he said that the most dangerous part of the D.C. fall frenzy may not be a shutdown or a debt ceiling default (which he views as unlikely) but a protracted fight over President Obama’s nominee to succeed Federal Reserve Chairman Ben Bernanke.

“If it’s noisy enough to make it seem as though the president might not get his nominee through that could cause quite a large reaction in the market because the direction of Fed policy is so important right now,” Hatzius said. He added that there has been “some very distinct moves” in the bond market as stories move on whether Larry Summers, Janet Yellen (or some other candidate) has the inside track. Presumably Summers would face the tougher fight but anyone Obama nominates is going to take heat from Republicans over the Fed’s easy money policies.

I have spilled a lot of ink – at least via the links – on the Fed nomination battle. My conclusion: The Fed nomination battle is disastrous for Obama. And I do think the Politico title bears thinking about because interest rates could react negatively to the uncertainty surrounding future Fed policy. Long-term interest rates are largely a reflection of expected future short-term future interest rates plus a term premium. So when you see yields move up, it reflects either an increase in term premiums from uncertainty or a change in the consensus view of the expected future path of policy rates. This means that rates are anchored by present rates, inflation expectations and the Fed’s reaction function. The Fed’s reaction function is the key variable here as the other two aspects are known quantities. It is assumed that the Fed will raise rates only if inflation is at a level that allows them to do so and so rates will go up based on the Fed’s tolerance for higher inflation.

Think about the Summers-Yellen fight in the context of the Fed’s reaction function. What I am saying here is that the Fed will only raise rates if there is a reason to do so because of increased inflation. There has been increased talk within the Fed about the Fed leaning against asset bubbles and the like but there is no indication that the Fed is planning to pursue a policy of raising rates to pop asset bubbles. Instead, we can assume that rates will rise if and when inflation does.

To me, that means that the real problem with Summers-Yellen is in terms of short-term uncertainty and medium-term term premiums more so than expected future paths of rates. Bernanke has admitted that he is fine with rates going temporarily higher if it chases down leveraged speculators reaching for yield because he knows that the Fed controls short-term rates. If inflation stays low, the policy rate will remain at zero and long-rates will normalize over time. The same has to be true about Summers-Yellen then. No one can think there is any discernible difference between a Summers and a Yellen Fed reaction function on policy rates. One might be more hawkish at the margin but, by in large, the reaction function is going to be the same. But the uncertainty is still there and that’s going to have some impact on the term premium.

This Bloomberg chart from July makes that case:

Of course, in the short-term, uncertainty can tip over into a real change toward expected rate increases just as it has done with Bernanke. But, as with Bernanke, that uncertainty will fade as it becomes apparent that the Fed’s reaction function is unchanged whether Yellen or Summers is the Fed Chair. The housing recovery can be killed off while we get there though. And that’s the short-term risk to the economy. So I think of the risks here as short-term interest rate spikes and long-term adjustments upward to term premiums. Nether of these is fatal to the recovery in my view.

Summary: Long-term interest rates are largely a reflection of expected future short-term future interest rates plus a term premium. So when you see yields move up, it reflects either an increase in term premiums from uncertainty or a change in the consensus view of the expected future path of policy rates. This means that rates are anchored by present rates, inflation expectations and the Fed’s reaction function. The Fed’s reaction function is the key variable here as the other two aspects are known quantities.

Taking a step back from the day-to-day headlines over the Fed succession battle, what we see now is a weak recovery and low inflation that worries the Fed. Asset prices have moved up considerably though. On the whole, unless the Fed is going to move pre-emptively to pop a potential asset bubble, I believe rates will remain at zero percent in the U.S. indefinitely. Therefore, the Fed will look to remind us that this is so. And doing this – divorcing interest rate policy from QE – will allow them to taper asset purchases sooner. Unless inflation ticks up a lot, that means we have a future of permanent zero rates, with quantitative easing as a lever to signal the level of policy accommodation.

I think this is a bad scenario as I outlined in the last subscriber post on how the United States gets deflation and becomes the next Japan. What we would need to see for this to be a good scenario is a rise in inflation, employment and wages that reduces household debt sufficiently to cause the Fed to raise rates before the next downturn hits and to lower them during recession. Without the increase in inflation, rates remain at zero, making interest rate policy a non-entity in the next downturn. At this point I don’t see this scenario as the default scenario. Without the rise in employment, the economy remains at stall speed, making the U.S. vulnerable to economic shocks. And without the rise in wages, debt remains unreasonably high relative to income, making deleveraging in the next downturn a problem to growth. Only one of these variables is moving in the right direction. Inflation and wages are stagnant or decreasing while employment is increasing at a moderate pace.

I still see US as the next Japan right now and the succession battle at the Fed doesn’t change this. The Fed’s reaction function is data dependent whether Yellen, Summers or someone else is the Fed Chair. And right now the data tell us permanent zero rates are the main variable in U.S. monetary policy.