Japan redux: Fed rate hikes are coming this year, but at what pace?
The title of this post is what the Fed wants us to believe. It wants us to believe that it is prepared to raise interest rates this year but that it will increase them slowly by assessing the data, hiking once and re-assessing, and then hiking again if the data warrant doing so. I believe the Fed. The Fed wants to raise interest rates and it will raise interest rates if the data are sufficiently robust to do so. The questions then become what are those data, how robust do they have to be and what are the trigger points for hiking further down the line. And beyond these questions, we need to ask what is the reaction from markets and the real economy. I think Japan’s experience is a good cautionary guide here.
As I add some thoughts below, I should add here that I am making forward-looking statements about what I think will happen, not what I want to happen. I am not talking my book simply because my book doesn’t matter. I don’t have the influence over markets r sway with policy makers that a Ray Dalio has. What I am interested in is what is likely to occur and that’s what I am writing about here.
Let’s review the record first. Back in October I wrote the following as the Fed’s tapering of QE came to an end: “It’s hard to take a bearish view on the cyclical progress the U.S. economy is making. This is why the Fed has felt comfortable ending its QE program. The Fed has wanted to turn away from QE and move toward forward guidance as its main tool for policy in order to normalize economic policy. In that sense, the bar was very high for the Fed to change its charted path, this month’s market turbulence notwithstanding. Because monetary policy is heavily reliant on expectations to feed through, especially with a program like QE, we should view tapering as tightening. But so far, the Fed’s tightening bias has not derailed the economy. Right now, the U.S. economy is doing well.”
This is the jumping off point for the Fed. It tapered and ended QE with the economy firing on all cylinders in terms of job growth and economic growth. Disinflation is a concern and the GDP data have weakened since then, but the Fed seems to be looking through that data for now.
The Fed’s Reaction Function
The paradigm the Fed uses consists of a few crucial elements:
- Inflation. The Fed wants to meet a dual mandate of price stability and full employment. As I see the Fed discussing this mandate, the inflation part is a medium- to long-term inflation path predicated on issues like market-based inflation gauges like the five year, five-year forward inflation expectations rate and the path of actual core inflation gauges like the core PCE index consumer inflation measure. From what I have heard Janet Yellen and other Fed officials say, they are comfortable with inflation as long as these measures are around or moving toward the 2% target. There is no indication whatsoever that the 2% target is the mid-point of a range. Rather all indications are that it is a target ceiling which would trigger rate hikes if reached. Thus, to the degree we are below the 2% target, the Fed is comfortable with inflation as long as it is around or moving toward 2%. Levels over 2% would trigger hikes unless there was elevated slack in the labor market.
- Jobs. The Fed looks at unemployment and inflation as trade-offs the closer we are to an imagined level of full employment. The Fed thinks of full employment, then as a level at which inflation begins to accelerate due to cost-push pressures as wages are bid up. The non-accelerating inflation rate of unemployment is thus considered full employment. I don’t buy into this paradigm. Moreover, in a world of global wage arbitrage and reduced union membership, the NAIRU concept is even less likely to hold, meaning that the Fed can allow unemployment levels to go much lower without the reduced slack in the labor market triggering consumer price inflation. But that doesn’t matter. What does matter is that Fed officials believe that NAIRU is important. And they have set the level at 5.0-5.2%
- Financial stability. In the Fed, there is increasing awareness that consumer price inflation and asset price inflation do not go hand in hand. The experience in the late 1990s and 2000, when the unemployment level dipped to 3.9% showed the Fed that you could have extremely low consumer price inflation levels at the same time as low unemployment and massive asset price inflation. Many in Fed circles have come to see this mix as particularly noxious and are thus concerned with the Fed’s impact on financial stability. Though they won’t say this directly, financial stability concerns do play a role in making the Fed more hawkish during periods like right now when asset markets seem elevated. I tend to call financial stability a stealth third mandate as a result. It is not on par with the first two but can tilt the odds toward a tightening bias when markets are elevated.
- Policy lag. Having said all of this, I should stress that the Fed also believes its actions work with a time lag, meaning it has to anticipate where the real economy will be in a few months in order to make policy decisions that will help rather than hinder its goal to promote longer-term price stability and full employment. This is particularly important regarding NAIRU because as we hit the levels that the Fed believes becomes operative, it will want to act before consumer price inflation rises, in anticipation of a rise that results from hitting NAIRU. If you listen to Yellen and other Fed policy makers it is clear that this is their thinking, and tells you why they are not as concerned that inflation measures show no signs of rising.
- Forward guidance. But, of course, the Fed would rather the bond markets move to where it wants them to move without it having to act. It would like to telegraph its intentions ahead of time because it needs forward guidance to steer markets as actual policy acts with a lag. If the Fed didn’t use forward guidance, the markets would be ambushed by Fed decisions, with the attendant negative consequences. Instead the Fed wants markets to know where it is heading so that, though there is a policy lag, the transition is smooth. Now, to make sure markets respond to the Fed’s guidance, the Fed needs credibility. And that means that it cannot make guidance, revise that guidance when the data fail to materialize and expect markets not to front-run its decisions. Time inconsistency is a big problem with forward guidance that can reduce credibility and lessen the Fed’s ability to move markets, something especially important at the zero lower bound.
The data at the Fed’s disposal
Now, going back to the actual economic data and the Fed’s reaction function, after the Fed tapered and ended QE last year, it became clear that it wanted to raise rates if the data held. In December, I wrote how the markets were misreading the Fed’s seriousness regarding rate hikes and how a strong dollar and divergent monetary policy was dangerous. And equity market fundamentals were already weakening at that time. “The EPS revision ratio, which is below one when earnings revisions are down, is now at 0.69 through November versus 1.11 in July. According to Gluskin Sheff’s David Rosenberg, the number hasn’t been this low since 2012 when QE3 was forced into action as a result. Energy names have been the leading culprit with the revision ratio at 0.20 in November, the lowest since April 2009, just after the cyclical bull market began. That number was 1.94 in June. Oil major BP’s announcement that it is cutting staff as the oil price declines tells you that more downward earnings are coming. But the earnings revisions are going down in consumer staples, industrials and materials as well.”
By January, it was clear the jobs data was good enough to get the Fed to hike rates. Here is how I put it, concentrating on financial stability as the factor tipping us toward rate hikes. “In the suboptimal world in which we live in which monetary policy rules the roost, the Fed is expected to do it all: maintain price stability and support full employment as a dual mandate. And increasingly the Fed has a stealth third mandate: maintain financial stability. It is this stealth third mandate which makes rate hikes likely. And I believe the macro data are robust enough that we will see hikes in June unless the macro environment really deteriorates. By June, we could be at 5.1 or 5.2% unemployment, with trailing 12-month average monthly job growth of 250-275,000. Irrespective of where inflation is, unemployment would be well past a level that traditionally has drawn a response from the Fed. If one looks at the Taylor Rule as a guide, the Fed should be hiking already. Again, I think the real economy is weaker than the headline suggests because of poor wage growth and still high private debt levels. But the conundrum is that imbalances are building and the headline employment situation is already at a place where the Fed is expected to raise rates.”
By February and March, the data were weakening enough to put some doubt on a June rate liftoff. The initial Q4 GDP data print showed consumption up at a 4.2% annualized pace but retail sales have been weak ever since, with figures falling for three months in a row from December to February. As I wrote early in March, “I should also point out that nowcasts for Q1 GDP are pointing to annualized growth with a 1% handle, well below current estimates. Andy Lees of the Macro Strategy Partnership says that the numbers are even worse according to the Atlanta Fed’s nowcasting. They have 1.2% versus estimates for 2.7% annualized growth for Q1. The differential comes via lower consumer spending, residential investment, and business investment via the oil patch. All of this makes sense given the bad weather we had in the Northeast in Q1 and the weak retail sales numbers we have had. But cutting out Q1 2014 from the rolling 12-month GDP numbers and we are still running at 3%+ for the last 12-months, giving the Fed plenty of room to hike.”
Now, much of the data weakening was weather-related, yes. And retail sales have bounced back in March. So the Fed seems to be looking through this data and saying that it can still raise rates as soon as June if the unemployment rate keeps falling. Only Evans and Kocherlakota are singing a different tune. All of the other Fed Governors and Presidents are saying June is on the table and that the Fed will hike this year. In terms of the economy and inflation, here are the data points that could put the Fed on hold. Take a look:
These figures point to decent personal income growth, more uneven consumption patterns and relatively stable core inflation. I think these three figures are the ones to look at regarding whether the Fed can hike rates.
If core PCE stays in the 1.2 – 1.8% range, the Fed will be unconcerned about inflation. And if personal income growth remains in the 3-4% annualized range, the Fed will feel comfortable hiking, even if the path of personal consumption remains weaker as it has been for the last three months. I see the Fed looking through consumption data as derivative and focusing on personal income as key to whether it can proceed.
At this point then, the jobs numbers become all-important. Going back to my points about the Fed’s reaction function, we have core inflation in a range where the Fed feels comfortable raising rates. And we have financial stability issues in the background. Knowing that policy acts with a lag, starting in June, the Fed will be looking at personal income and wage data to gauge whether the current level of unemployment is low enough compared to their 5.0 – 5.2% trigger range to begin raising rates. Put differently, if core inflation and personal income growth stay where they are and the unemployment rate drops to 5.2%, the Fed will have to decide whether to raise interest rates. If we hit 5.0%, rates will definitely rise.
A major reason I see the 5.2% level as a threshold and the 5.0% level as a trigger is because of forward guidance credibility. Just a few months ago the Fed’s range for normal unemployment was 5.2 – 5.5% and then we approached that level exceedingly quickly, in March already, quicker than the Fed expected. This put the Fed in a quandary because, while it wanted to raise rates this year, it did not want to raise rates too quickly. So it moved the goalposts. It changed the range to 5.0 – 5.2%. That is something that reduces credibility and encourages front running because it highlights the time inconsistency problem.
Now, I don’t think NAIRU is a useful economic concept. And, anyway, the Fed does have some academic support for moving the range down. But none of this matters. What does matter is that the Fed gave guidance and then changed that guidance. It effectively said that it would decide about interest rate policy based on the approach to a specific range of unemployment outcomes between 5.2 and 5.5%. Then it changed that range down as the events on the ground changed. Sure, one can intellectually justify such a move. However, such a move will still reduce the credibility of forward guidance. And I think the Fed knows this. For this reason alone, I believe 5.0 – 5.2% has become a threshold to trigger range for rate hikes.
Fed statements on hiking and the post-hike reaction function
What happens once the Fed raises rates the first time? Janet Yellen told us in a speech last week in a speech titled “The New Normal Monetary Policy” that she gave at the San Francisco Fed, which was all about normalizing monetary policy. She said:
“The FOMC will, of course, carefully deliberate about when to begin the process of removing policy accommodation. But the significance of this decision should not be overemphasized, because what matters for financial conditions and the broader economy is the entire expected path of short-term interest rates and not the precise timing of the first rate increase.” [emphasis added]
That’s a ‘one-and-done’ pledge. And I don’t think the markets appreciate this yet. The Fed is saying: “We will definitely raise rates if the data evolve as we think they will. In fact, if they do evolve as we believe they will, we will raise rates as soon as June and certainly by September. But then we will stop and re-assess. We are going to be very deliberate and cautious here because we are at a delicate time in the path for interest rates.” Some of why the Fed is articulating this strategy has to do with its unease about the tools it has to maintain the Fed Funds rate at the targeted level given the amount of excess reserves. But the caution is also due to its desire not to create ‘another 1937 fiasco’. Now I would point to 1997 and I have some thoughts on why shortly. But I want to return to the first hike and nail down what Yellen is saying about it.
Here’s what she said in her San Francisco talk that I would highlight above all with emphasis added:
I am cautiously optimistic that, in the context of moderate growth in aggregate output and spending, labor market conditions are likely to improve further in coming months. In particular, and despite the somewhat disappointing tone of the recent retail sales data, I think consumer spending is likely to expand at a good clip this year given such robust fundamentals as strong employment gains, boosts to real incomes from lower energy prices, continued increases in household wealth, and a relatively high level of consumer confidence. Of course, not all sectors of the economy are doing as well: dollar appreciation appears to be restraining net exports, low oil prices are prompting a cutback in drilling activity, and the recovery in residential construction remains subdued. But overall, I anticipate that real gross domestic product is likely to expand somewhat faster than its potential in coming quarters, thereby promoting further gains in employment and declines in the unemployment rate.
This paragraph is very important because what it signifies is that she is bullish on the economy and that she is looking through weaker data points on retail, exports, oil drilling, and housing. Yellen is saying, “I know that shale is taking a hit and that weather knocked over retail and housing and that the strong dollar is a headwind. It doesn’t matter, the totality of the data I see is strong. And because monetary policy acts with a lag, I am going to look through these data points and get the FOMC to raise rates soon in order to head off inflation before it gets started.” Moreover, Yellen says specifically that oil price declines boost real incomes. She says that higher asset prices boost wealth and consumer confidence. And she says that the employment data are robust. That is an unequivocally strong statement about “robust fundamentals”.
Bottom line: We are on a collusion course with the first rate increase right now, and weak retail, business investment, and export data will not derail this.
The problem here is the Japanese precedent. An already demographically-challenged Japan had a terrific crash in land prices and shares as the 1990s began. The result was enormous levels of bad debt as shares and property that underpinned many loans provided insufficient collateral. The Japanese dithered in recapitalizing their banks. And so when the next cyclical downturn hit due to the policy errors of the central bank and central government in both tightening, the economy slipped into ‘permanent’ deflation.
Here’s what happened: The consumption tax was increased in April 1997. And a banking crisis began very rapidly in November of that year, continuing until the spring of 1999. The Bank of Japan’s monetary policy committee brought rates down to zero for the first time on 12 February 1999 by a 8-1 vote. The economy started to recover just at this time. And then on 11 August 2000, the Bank of Japan raised rates again, just a quarter of a percent. Recession started two months later and the consumer price inflation rate turned sharply negative afterward. Deflation has been entrenched ever since.
Now, certainly timing was awful here because the fiscal tightening coincided with the Asian crisis. Actually, some believe the Bank of Japan’s threat to raise rates in May 1997 to protect the Yen is what precipitated the meltdown in Asia that began with the Thai Baht, which was immediately hit with speculative attacks. But, it’s clear that the turmoil in Asia combined with Japan’s fiscal tightening made the Japanese domestic economy vulnerable. Then, when the global TMT bubble popped, where the Japanese were prominently featured – think of the NTT Docomo IPO for example – the Japanese were raising interest rates while everyone else was cutting. The Fed began cutting from 6.25% on 16 May 2000, ultimately getting rates down to 1%. So the Bank of Japan was moving in the wrong direction just as the global economy was slowing. And this helped tip the economy into recession and deflation.
I would argue the Armageddon scenario I presented two days ago puts the Fed into a similar situation i.e. tightening while the rest of the world is easing. And in that sense there is a parallel to Japan. For Japan, the outcome has been disastrous because, politically, there was no will to run large scale deficits and employ the draconian private sector credit writedowns necessary to bring the economy back to full employment and wipe the slate clean. Instead, Japan allowed the economy to lapse into recession time and again, producing a sharp deterioration in the fiscal balance that allowed the government debt burden to balloon without fully addressing the structural problems in the private sector. Thus while Japan started the 1990s with a fiscal balance in surplus and government debt at 20% of GDP, the fiscal balance is deeply negative and government debt to GDP has ballooned to 200%.
Now that the demographics have caught up to Japan, the country’s external position has reversed as well. Trade deficits will become de jure and the whole concept of domestically financed deficits will disappear.
Japan is in a policy cul de sac. The reason it ran yet another disastrous consumption tax hike that slowed the economy and pushed the country back into deflation is that the Japanese don’t know what to do. They do not know how to reduce the mountain of government debt built up as it used deficits to transfer private debts onto the state as it employed zero rate policies and fiscal stimulus that kept unproductive, zombie companies alive. And with poor demographics reducing nominal GDP growth, there is no chance that growth will help the Japanese escape this dilemma. I have suggested a wealth tax is likely at some point because all other options have failed – including quantitative easing, as the increase in inflation has proved temporary and was never going to boost nominal GDP in the absence of wage growth.
This is what could await the United States down the line if it doesn’t grasp the nature of its political and economic constraints.
I believe rate hikes are coming this year. The Fed is going to begin emphasizing the path of rate hikes and the data dependence of those hikes. But the market is not appreciating the degree to which the Fed wants to raise rates. And that sets us up for an abrupt re-assessment by the market going forward. While it is not clear how this will end, risks are weighted to the downside.