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.
READER COMMENTS
JP
Nov 28 2018 at 3:17pm
Great post, particularly points 5 and 6. Along these points, I have assigned the following op-ed paper assignment for my Macro students the last few semesters:
“Given the current economic climate and the dual mandate of the Federal Reserve (FED), should the FED continue to raise the federal funds rate? Consider whether the FED is ‘maximizing employment’ according to their own criteria and whether the FED is achieving its 2 percent inflation target and whether the market believes the FED will hit its 2 percent target (i.e. consider the 5 and 10 year break-even inflation rates as well as the 5-year, 5-year forward inflation expectation rate).”
Scott Sumner
Nov 28 2018 at 6:18pm
JP, Thanks, and those are the right questions to ask.
Benjamin Cole
Nov 28 2018 at 7:47pm
Good post.
Matthias Goergens
Nov 29 2018 at 2:04am
The third valid form is to argue for free banking and private currencies, I guess? Ie criticise the Fed’s existence?
It’s also interesting that the markets not only tell you what fed policy they expect on average, but also how confident they are in that prediction. Ie if a wide enough portfolio of derivatives are traded, you can work out the variance and also some conditional probabilities. (Otherwise, you can probably glean something from bid-ask spreads? But perhaps not.)
It would be appealing, if eg the American federal government would also issue tax take indexed bonds. Just like you are arguing for NGDP indexed bonds or other instruments to run an NGDP prediction market.
(The tax take index bonds might be popular with both the electorate who can be promised that moving mostly to those bonds will make future tax cuts pay for themselves, and with rational investor who will notice that unexpected major tax cuts are unlikely.)
Thaomas
Nov 29 2018 at 9:13am
My criticisms have been that the Fed has an inappropriate target for the “price stability” half of it’s mandate. It should be targeting the price level rising at 2% (or maybe a bit more) from the pre-2008 trend. I think on those grounds the price level is not high enough and requires more monetary stimulation.
As for the full employment half of the mandate, that’s more difficult. Probably a labor hours trend level would be best. On those grounds, too, it looks like we are still below target also requiring more monetary stimulus.
Whether the additional monetary stimulation should be done with lower FF target, more QE, reducing the interest paid on reserves, buying foreign exchange, is a technical matter I’d leave up to the Fed.
Mark Z
Nov 29 2018 at 10:10am
I don’t know, I find targeting full employment somewhat problematic given the inconstancy of the natural rate of unemployment and non-cyclical reasons for people working fewer hours (I’m not sure I believe current trends actually do justify more stimulus, which depends on why exactly labor force participation remains historically low). I’m not sure I trust the Fed to discern/decide what the trend should be in average hours worked.
Brian Donohue
Nov 29 2018 at 10:34am
Good post, but:
Why continue with the dot plot then? It’s been a work of fiction for years and seems entirely counterproductive. While this remains part of the Fed’s official story, people will attach significance to it.
10-year TIPS have a lower yield than 5-year TIPS today. Hiking according to the box plot would surely invert the curve. Unforced error. Also, the Fed has shrunk its balance sheet by $350 billion in the past year, but not a peep from anyone on how this policy interacts with the FFR. Clearly, this is a tool for managing monetary policy while maintaining a sensible yield curve.
I interpret market reaction as simple relief that the Fed will continue to be data-dependent rather than more hawkish. Data on inflation, employment, and wages continue to indicate that the recovery has some road in front of it yet and little danger of overheating.
Agreed on first part, but why do you invoke the view of a bunch of “no skin in the game” economists (who have a track record as bad as the box plot) on inflation predictions rather than Mister Market (TIPS spreads), which estimates CPI below 2% as far as the eye can see? Seems inconsistent with your argument in #1, and everything I know about you actually.
Yes, pundits are hopeless on monetary policy.
I think the Fed has done great for the past several years. Thank God they have listened to the markets and behaved in a data-dependent manner, but I can’t shake the picture that, in a sense, the markets dictated a policy of restraint to a Fed that has been otherwise eager to “normalize” for several years, without understanding that we have arrived at the new normal.
Brian Donohue
Nov 29 2018 at 10:58am
OK, so I googled “Jerome Powell Fed Balance Sheet”, and there are a couple good links.
This is from Patti Domm at CNBC in September:
https://www.cnbc.com/2018/09/12/the-fed-is-trying-to-finally-get-back-to-normal-after-the-crisis.html
You haven’t had much to say about the balance sheet lately, but the shrinking has continued apace.
And Randall Forsyth at Barron’s did a pretty good take on Powell’s speech and the market reaction.
https://www.barrons.com/articles/why-did-federal-reserve-chairman-powell-back-off-on-rate-hikes-1543435387
Cheers!
Scott Sumner
Nov 29 2018 at 1:00pm
Thaomas. That would have been a good idea back in 2008. To do that today would be a disastrous mistake.
Brian, I’ve never seen any studies suggesting an inverted TIPS yield spread is anything to worry about.
TIPS spreads are useful, but they are not a precise market forecast of inflation going forward. They are distorted by factors such as lags in the CPI adjustment, which interacts with the volatile oil market. There’s also a risk premium. They are useful, but must be handled with care. I also take the consensus economists’ forecast with a grain of salt, but at least it’s less self-serving that the Fed’s own forecast.
I think your final point of criticism is more applicable to the 2013-16 period, not the past two years.
On your second post, I favor shrinking the balance sheet.
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