"I think markets may be extrapolating from our recent behavior and thinking all we do is delay.”
That’s from Jeffrey Lacker and it’s entirely accurate. Lacker has been a vocal critic of the FOMC’s easy money policies for years and on Monday, The Washington Post published an exclusive interview with the Richmond Fed chief.
Back in January, the Fed got a peek at what markets will look like in a world where the FOMC’s efforts to normalize policy are set against depressed commodity prices, EM outflows, and simultaneous easing by other developed market central banks.
What they saw wasn’t pretty.
After January’s harrowing market moves, the monetary powers that be apparently decided that now is not the time to rip off the bandaid, so to speak. Had the Fed hiked in March, the dollar would have likely soared, driving crude prices into the teens and triggering a sharp decline in risk assets. That rather unpalatable series of events could not be allowed to unfold. And so, the Fed sat on its hands. Stocks have rallied smartly off their February 11 lows, crude has rebounded, and everyone is happy - well, everyone except for the Japanese who are struggling to keep a lid on the yen lest the country’s exporters should all go belly up.
But while the music is for now still playing, Lacker warns that the Fed has fallen behind the curve. “If you look at the benchmarks for where rates ought to be, these are relationships between employment and inflation and the funds rate that have characterized our behavior when we’ve been successful in the past,” Lacker told the Post, adding that “those benchmarks indicate that we ought to have moved several times by now [and] the longer we delay, the more we’re falling behind.”
Indeed. What’s interesting here is that the Fed wants to have their cake and eat it too. That is, they need to keep long-term rates low in order to remain accommodative in a challenging environment, but they need to raise short-end rates in order to reestablish some breathing room so there’s at least some countercyclical policy ammunition left if and when the US economy rolls over.
With that in mind, Bloomberg is out with a piece on Monday documenting the plethora of analysts who have recently revised their 10-year Treasury yield forecasts lower. “Investors expect a slower pace of U.S. economic growth than they did last year, Treasury yields are more sensitive to global monetary easing, and investors don’t want to take much risk by betting on Federal Reserve tightening,” Bloomberg writes, citing a JPMorgan note out last Friday. The bank’s target is now 1.9%, lower than Goldman’s 2.4% target but not nearly as bullish as Citi’s 1.5% call.
Ironically, the extraordinary measures adopted by foreign central banks in Europe and Japan may well help the Fed achieve what on its face looks like an impossible task. With rates sitting in negative territory in developed markets outside the US, Treasury yields look rich by comparison. That’s driving demand for US government paper and that demand is helping to keep the long-end anchored. Here’s how Citi described the dynamic earlier this month:
“With little in the way of wage inflation at the moment, there is more room for the Fed to stay on the sidelines. The front end is priced with only a slight term premium for the next two years, and there’s not much room to rally here in the near term. However, the longer end of the curve arguably has more room to move. We have been of the view that the 10y is in a 1.5% to 2% fair value range and with the 10y sitting squarely in the middle of the range, where do we go from here? We are partial to the view that a test of 1.50% is highly likely. 1.50% on 10s might look like we are pressing onto all time lows from 2012. Looked in isolation, it may appear to be the case. However, when looked at from a different angle, i.e. in the context of spreads to other sovereign curves, it becomes clear that US rates are still high. 1.50% in 10y rates would not be anywhere close to the yield differentials that existed with the rest of the world in 2012. Take Japan as an example. The yield pickup of USTs over 10y JGBs for example was 65bp in 2012 vs. a meaty 185bp now. No wonder Japanese buying of USTs accelerated in February and March.”
Yes, “no wonder.” What that means is that as long as other central banks continue to push further into the Keynesian abyss, the Fed can count on strong demand for long-dated US paper. That should put pressure on yields even as the Fed Funds rate rises.
Be that as it may, Lacker’s colleagues seem to be looking for any and every excuse not to hike rates. The latest NFP print is a good example. “The jobs report indicates that payrolls growth may be slowing down - not entirely surprising given that the capacity for companies to hire in a slowing revenue environment is limited, and also because the economy is gradually getting closer to full employment,” Citi wrote in the same note cited above.
Of course the data out of the US actually looks decent - if only by comparison. The real reason why the Fed has fallen behind is that the FOMC has become the steward for the global economy. The Eccles building is now home to a kind of global stability watchdog whose policy decisions are dependent upon what’s happening in FX and capital markets. That, Lacker says, is dangerous. Here’s what he told The Post when asked about the Fed’s reaction function:
“I think the question about reaction functions is a good one. These benchmarks I’m talking about come out of the reaction functions that have been shown to have worked well in the past. That evidence is both empirical in the sense that the times that we followed that pattern of behavior we did pretty well. Times that we departed, we did pretty poorly. There’s good economic grounds, there’s good theoretical grounds, for thinking that as well.”
Right. But don’t expect the FOMC to listen to Lacker or to suddenly adopt a hard Taylor Rule in the interest of getting back to some semblance of rule-based, truly data dependent policy making. And as long as inflation expectations look like this…
...Yellen can claim there’s still work to be done and that there’s no danger of prices suddenly getting out of control. On that note, I’ll close with one final quote from Lacker:
“Monetary conditions can shift relatively rapidly. Maybe not overnight, but over the course of six, nine, 12 months, conditions can shift pretty decidedly. A good example of that was mid-2003 to 2004. We swung 180 degrees from a fear of deflation to strong evidence that inflation was rising and we needed to tighten policy. I think we’re in a situation like that now.”
