Some thoughts on Powell's speech
The stock market rose strongly after Jay Powell seemed to adopt a slightly more dovish tone in a speech today:
The Federal Reserve chairman declared US interest rates are closing in on “neutral” levels, triggering a stock market rally as investors interpreted the comments as a signal the central bank is preparing to slow down its rate-rising programme.
While he defended the Fed’s recent gradual rate hikes, Jay Powell said the central bank will be watching new economic data very closely as monetary policymakers decide what to do next.
Rates are hovering “just below” estimates of neutral — the level that neither causes growth to accelerate nor to slow down — the Fed chair said, in a possible sign that policymakers may decide they do not need to lift them much further.
As I’ve argued on numerous occasions, interest rates are not the right way to think about the stance of monetary policy. Indeed the strong reaction in the stock market was entirely disproportionate to the tiny fall in the 10-year bond yield:
Government bonds rallied as yields turned lower. The yield on the benchmark 10-year US Treasury was down 0.7 basis points at 3.0498 per cent, having been up by 1.1bp before Mr Powell spoke. The yield on the more policy-sensitive two-year note was down 2.4bp at 2.8066 per cent.
Stocks move up and down for many reasons, but when stocks move strongly immediately after very specific policy guidance from a top Fed official, then monetary policy is the likely cause of the market move. So what’s actually going on here?
1. One takeaway is that people should not pay too much attention to the dot plot, the Fed’s expectation for the future path of interest rates. For many months, Fed officials have been saying that they planned another 4 or 5 rate increases, whereas the market has been predicting only two (including the December rate increase that is now widely anticipated.) Markets can predict future Fed behavior better than the Fed itself.
2. There has been entirely too much discussion of the looming inversion of the yield curve. These forecasts were based on an inappropriate methodology—mixing Fed and market forecasts. Thus people were comparing the Fed’s expected future short-term rate with the market’s expected future long-term rate, and finding evidence of a possible inversion in another year or so. But the Fed’s forecast was never worth taking seriously. Market forecasts suggest that yield curve inversion is not likely to occur in the next few years, although it’s certainly a possibility.
3. The big jump in stocks was not caused by a big drop in future expected interest rates—as noted the 10-year yield barely budged—rather by an expectation of a more expansionary monetary policy. But isn’t “lower future interest rates” and “more expansionary monetary policy” the same thing? No, expansionary policy affects rates in a myriad of ways. Never reason from a price change. The liquidity effect of easier money tends to lower rates, whereas the income and Fisher effects tends to raise future expected rates. The net effect is ambiguous, and pundits err in focusing on interest rates as an indicator of the stance of policy.
4. Powell’s slight move in a more dovish direction does not indicate that the Fed erred in the previous rate increases. If that were clearly true, then the Fed would presumably abandon its planned December rate increase. Instead the December rate increase is still likely, and the consensus forecast of private sector economists is for 2.1% PCE inflation going forward, as well as very low unemployment. Policy still seems roughly “on target.” That’s not to say that a year from now we won’t view current policy as having been too easy or too tight, rather that as of right now it’s not obviously off course, as it was obviously off course during 2008-13, for instance. Policy is currently “data driven”, which is entirely appropriate.
5. It’s not helpful when pundits express an opinion on interest rates. If they criticize the Fed for setting rates too high or too low, it’s unclear whether they are claiming policy is too easy or tight to hit the Fed’s 2% inflation target, or whether that target is inappropriate. This also applies to President Trump’s recent comments on interest rates, which are also quite ambiguous.
6. Criticism of the Fed should take one of two forms. Either clearly spell out what’s wrong with the current Fed target, or accept the target and clearly spell out why the current stance of policy is unlikely to hit the target going forward. (Or both.) I see very few pundits clearly make this distinction, and hence most Fed critiques are not worth taking seriously. It’s not helpful when people say they favor higher rates because they worry about elevated asset prices, or they favor lower rates because they like “growth”. Those statements are completely incoherent without an explicit statement on their view of the 2% inflation target. That is, should the Fed raise or lower the inflation target, and if the target is kept at 2% should inflation be procyclical or countercyclical? Those are the real issues.