This week the Federal Reserve’s Open Market Committee met. As was widely expected the Fed cut rates by 0.25%, potentially setting itself on a path to greater easing in subsequent meetings in September and December. The financial media is positioning this cut and further potential action as a set of “insurance” rate cuts.
We have previously opined on the yield curve and what we think it may or may not be saying about the direction of the US economy. In this post we’re going to talk about the Fed’s mandate, the Fed’s policy, what the Fed is and is not saying, and what we think the Fed is doing.
The Fed’s Dual Mandate
The Federal Reserve has a dual mandate to promote full employment and price stability. This is different from other central banks like the European Central Bank, which only has a mandate on price stability. Serving two masters is quite difficult, and conventional economic theory suggests that these two masters are often at odds with one another. A robust job market should lead to higher wages and potential price instability (inflation), while too much slack in in the labor economy and wages typically stagnate or fall creating a different kind price instability (deflation). The Fed’s goal is for a Goldilocks type economy, not too hot, not too cold, just right so that people are employed, and prices don’t rise too fast or start to fall.
Savers aside, we think most economic actors like a little bit of inflation. The financial system is built on an assumption that prices tend to rise over time, falling prices gum up the works and slow down how fast money moves through the economy. Deflation also tends to be destabilizing to the banking system, but in contrast some inflation helps borrowers by reducing the value of the amount borrowed in real terms.
As far as we can tell, in the developed world there are not convincing examples of persistent deflation being defeated by central banks creating inflation in a deflationary environment. While there are some key differences, the Japanese case is instructive, as they have been fighting deflation there for nearly three decades. In 2002 then Fed Governor Ben Bernanke famously said he knew how to create inflation in Japan. He’d get a helicopter and start dropping money from the sky, thus earning himself the nickname “Helicopter Ben”. The helicopter dropping money is really a metaphor for quantitative easing (QE), where a central bank buys government and potentially other bonds with money created by the central bank. The Bank of Japan has been through multiple rounds of QE over the years and this has not broken the deflationary hold on Japan’s economy. The ECB is currently trying to create inflation in Europe utilizing the same strategy. It is unclear if monetary policy is an effective tool for fighting deflation, but policy makers keep trying.
Contrast all this with what policy makers know about dealing with inflation. Policy makers have shown they know how to address inflation through monetary policy. Paul Volker broke inflation nearly 40 years ago by raising rates and choking off the money supply, but they have not proven they really know how to address deflation. We think policy holders are (rightfully) scared of deflation because they are not sure how to deal with it effectively. Thus, in early 2012 the Federal Reserve adopted an inflation target of 2%.
What’s going on right now?
Right now, unemployment is below 4%, inflation is below 2%, and second quarter GDP estimates came in above 2%. This seems like a bowl of economic porridge that Goldilocks would like, so why the “insurance” rate cuts?
The short answer is, we do not think these are insurance rate cuts, we think the Fed is backtracking from a policy error. It is unlikely the Fed admits this, or that the members even think of it this way, but we think it went too far and overestimated the level of neutral real interest rates. Right now, we think the Fed is engaging in contractionary monetary policy and if it leaves rates at this level too long, it could wind up causing a contraction.
Let’s take a look at the Fed’s preferred measure of inflation, Core Personal Consumption Expenditures (PCE). As we stated earlier, in 2012 the Fed started targeting a Core PCE level of 2%. However, this was really being more explicit about their goals publicly, as they had internally targeted 2% for a long time. The graph below, which takes PCE and subtracts 2%, is instructive. What’s notable about this graph is that inflation has only hit 2% twice in the last decade and has not run meaningfully above the hurdle rate since the early 1990’s. One would be forgiven for wondering, if the Fed is targeting 2%, whether they can consistently hit the mark.
The inflation level is important because real rates are a byproduct of nominal rates and inflation. The inflation measure hovering stubbornly around 1.5%, a short-term rate at 2.5% produces a real rate of 1%.
What do we think?
We think there are some persistent deflationary headwinds in the economy, whether they be the debt levels, demographics, or technology. Going into all of those headwinds is beyond the scope of this blog post, so we would rather focus on a simple question. In a world awash in too much capital, with short term rates negative in much of the developed world and persistent deflationary biases in the global economy, why should the short-term real return on low risk debt be meaningfully above 0%? It is a hard question to answer, but we think market-based short-term real rates would be lower if the Fed was not setting them. In our view this new path could be considered a policy error correction and not a set of “insurance” cuts. While we think the Fed is trying to get ahead of a slowdown, we think it is trying to prevent being the cause of that slow down.