NNIP: A change in Fed strategy could be on the horizon

NNIP: A change in Fed strategy could be on the horizon

Fed
Federal Reserve.jpg
  • The Fed’s strategy of staying on hold represents a truce between hawks and doves
  • A rate hike in the next few years could stem from continued declining unemployment or a persistent risky asset boom
  • In the current low-inflation environment, Fed rate cuts look likelier than a hike

In 2019 markets were largely driven by Fed easing, which inspired other central banks to ease as well. For 2020, the additional degree of global monetary easing priced by markets is much more limited and mostly confined to emerging markets. However, this is not to say that market participants can safely ignore central banks. There is a real possibility that central banks will cause significant volatility in the coming year, not because of what they will do, but because of what they will say. This is because the goalposts in monetary policy are shifting in a way that could have a persistent impact on markets. Both the Fed and the ECB will complete their respective strategic reviews this year, and it is not inconceivable that discussions around this will get mixed up with the tactical outlook for policy.

Fed tactics: a truce between hawks and doves to remain on hold

By launching its review of monetary policy strategy, tools and communications last June, the Fed showed wisdom by beginning at a point where monetary policy was near its long-term equilibrium. The economy was close to full employment, inflation was a little below target and expected to converge towards it, and the real policy rate was not far removed from estimates of the neutral interest rate (r-star) and expected to converge to it as well.

Since then, two main things have changed. Inflation continued to surprise on the downside with some spillover to inflation expectations, while trade uncertainty pushed r-star lower and forced the Fed to push the real policy rate lower as well. Despite this, the Fed should have an easier time separating strategy from tactics than the ECB, which faces inflation expectations that are low for the foreseeable future and still slipping. Still, even for the Fed, strategy and tactics may get mixed up. Thus, Fed policy is beset by uncertainty in the medium to longer term.

‘Fed policy is beset by uncertainty in the medium to longer term’

Willem Verhagen, Senior Economist, Multi-Asset

The Fed’s notion that rates will remain on hold ‘for a time’ may well morph into “for a very long time”, but reality may not align with this prediction. The risks surrounding this base case are huge and skewed to the downside. In this respect, we believe the policy rate is more likely to decrease than to increase. A US recession in the next two to three years is not inconceivable; if this happens, it may push the US economy deeper into secular stagnation territory.

From a tactical perspective, the prospect of policy staying on hold “for a time” arguably represents a compromise between different factions in the Federal Open Market Committee (FOMC). The insurance cuts were not uncontroversial. The Fed had three reasons for cutting rates and each FOMC participant applied a different relative weight to each reason, leading to dissenting voices. What’s more, the hawks had additional reasons that the majority did not share.

The first of the commonly shared reasons for insurance cuts was that trade uncertainty and weaker global growth were pushing r-star down, at least in the near term. Thus, the Fed had to push down the actual real rate to prevent policy from tightening. Second, there was an argument for pre-emptive leaning against downside risks. Providing a “monetary stitch in time that saves nine” is more important in a world of low r-star and low inflation than in a world in which the zero lower bound is not on the horizon.

Third, inflation had surprised on the downside in 2018 and inflation expectations remained low. This provides a strong argument for a “strategic dovish bias” – i.e., for keeping the real policy rate below r-star for a prolonged period, even if growth momentum accelerates. This argument indicates that strategy and tactics cannot be completely separated because the desire to generate above-target inflation in the later stages of the cycle is part and parcel of the strategic review.

Fed hawks were somewhat sensitive to these arguments but also took other considerations into account. One further consideration is that insurance cuts can endogenously increase political risks by protecting politicians from the financial and economic consequences of their bad policy choices, at the cost of depleting the valuable and limited stock of conventional rate ammunition. Furthermore, insurance cuts can increase financial stability risks by triggering an excessive search for yield. These factors must be weighed against the risks to financial stability from a persistently lower nominal growth path that may result from a lack of insurance cuts.

‘The Fed should not become a slave to market expectations’

Willem Verhagen, Senior Economist, Multi-Asset

Finally, the Fed should not become a slave to market expectations. There is an obvious feedback loop between Fed policy and financial conditions. Ideally the Fed should be the dominant player in this game by setting policy to attain its twin objectives at all times. However, this is easier said than done. If the market starts pricing Fed cuts, the Fed could be forced to deliver to prevent an excessive tightening of financial conditions, which could induce the market to start pricing further cuts in a vicious cycle.

The strategic review and possible implications

Meanwhile, the Fed’s strategic review is centered around three issues: strategies, tools and communications. The main motivation is to prevent the “Japanification” of the US economy, which could result from a persistently low r-star level. With regard to strategy, the Fed has ruled out a change to the 2% inflation target. However, it intends to increase the target’s credibility by introducing a make-up strategy, whereby a period of persistent, albeit moderate, inflation overshoots will compensate for a period of persistent inflation undershoots. The Fed will thus ensure that inflation is equal to the target on average in the long run, which should anchor inflation expectations.

The inflation outlook is thus the lynchpin connecting the Fed’s tactical policy considerations and the strategic review. Because the review’s outcome remains unknown, it is uncertain what this will mean for Fed policy in 2020. Inflation could surprise on the upside after all, or a combination of buoyant risky asset markets and strong underlying growth could indicate that r-star is rising again. The Fed would likely respond by remaining on hold for the foreseeable future and could ultimately even implement the one hike now embedded in the dot plot.

Conversely, inflation pressures could remain relatively muted, or the combination of asset market and real economic performance could suggest that r-star remains around its current level. In that case the Fed could be on hold for much longer, possibly more than two years, or it could cut rates to reinforce the credibility of the outcome of its strategic review.

 

This type of policy action to enhance the credibility of a new regime essentially amounts to changing behaviour. Crucially, the Fed will not respond to improved nominal growth by tightening policy. All else being equal, this could be positive for risk appetite. US real rates would decrease for some time before increasing again, which could cause the dollar to weaken, especially because the US has much more room to decrease real rates than Euroland or Japan. Improving global growth could reinforce this trend because this typically reduces demand for safe assets, of which the US is among the most important producers.

This should ultimately steepen the US curve because the short end will be tied down by the strategic dovish bias while the long end will be pushed up by higher inflation expectations. Nevertheless, this steepening may not happen in earnest before investors see proof that US inflation is increasing and that the Fed is relaxed about it. Moreover, the steepening could face the headwind of continued high global demand for safe Treasuries in a secular stagnation world, where nominal bonds are an attractive hedge against low inflation outcomes. Finally, the combination of improving nominal growth and a Fed that remains on hold should drive equity and credit risk premiums lower.

‘The further the unemployment rate falls, the bigger the risk that the economy will run into hard constraints on labour supply’

Willem Verhagen, Senior Economist, Multi-Asset

Naturally, there is always the possibility of Fed tightening. The Fed is aiming for a moderate overshoot of the target; if the unemployment rate were to start declining at an accelerated pace from current levels, the Fed would probably hike in an attempt to slow this decline. The further the unemployment rate falls below what is already a historically low level, the bigger the risk that the economy will run into hard constraints on labour supply, which may elicit a non-linear reaction in wage growth.

Still, this scenario seems unlikely. To push the unemployment rate down much further, the economy would have to shift into higher gear, which is inconceivable without a sustained increase in private investment growth. Such an increase would also push up productivity growth, dampening the inflationary consequences of higher growth.

A more plausible scenario for a rate hike involves a persistent risky asset boom, which could make the Fed more worried about financial stability risks. After all, bubbles pose a threat to price stability in the longer run because they are typically strongly disinflationary after they burst. It is unclear to what extent monetary policy is the appropriate instrument to deal with bubble risks. What is clear is that a strategic dovish bias may increase the risk of bubbles developing. This risk must be weighed against the possibility of the dovish bias pushing nominal GDP onto a permanently higher and steeper path, which would support financial stability.

Rate cuts look likelier than a hike

A Fed rate hike in the next five years is certainly not inconceivable. Nevertheless, a rate cut or series of cuts seems much more likely. This is primarily because inflation is still too low and it would take a substantial increase in worker bargaining power to generate a “significant and sustained” move to levels above 2%. The Fed is betting that higher growth will do the trick; this is possible, but it could be accompanied or driven by a sustained rise in capex growth that pushes up productivity growth.

Moreover, there is a decent risk of the economy slipping into a recession sometime in the next few years, either because of a sustained flare-up in political uncertainty or because of a “death by a thousand cuts”. If this happens, it may push the US economy deeper into secular stagnation territory, with sustained further declines in r-star and inflation expectations.