Fed Chairman Powell roiled global markets yesterday in his speech before the New York Economic Club. Upon further consideration, markets may want to rethink the knee-jerk reaction. This piece explains why.
Fed Chairman Powell appears to have tilted more dovish. Or has he? After saying back on October 3 that “we’re a long way from neutral,” Powell said yesterday that we are “just below” the broad range of estimates for the neutral rate now. This was taken as a major dovish shift, but we think markets need to recognize a very subtle but important distinction here. In the September Fed Dot Plots, the range of Fed estimates for the longer-term neutral Fed Funds rate was a rather broad 2.5-3.5%. With the current Fed Funds target range at 2.00-2.25% (and widely expected to move to 2.25-2.5% next month), Powell was simply stating the obvious.
Yet markets were clearly biased to read these comments in a dovish way. We continue to believe that this is an incorrect read. Economic conditions have not shifted that much over the past few weeks, as the US economy continues to grow above trend and the labor market is near full employment. US financial conditions (as measured by the Chicago Fed) are near record looseness despite the Fed’s eight rate hikes to date. Until financial conditions tighten more, we fear that the Fed is falling behind the curve. A dovish message is not the right message to send to markets, in our view.
Chicago Fed National Financial Conditions Index
To state the obvious, Fed messaging could use some work. Yes, Powell is still fairly new to the job and is still learning the ropes. Still, he should have realized that markets were likely to take his comments in a dovish way. And the fact that Powell said this a day after Trump’s criticism is bad optics. We’re not saying Powell bent to Trump’s will, but even the slightest appearance of doing so is not good. The Fed has always prided itself on its independence and we are disappointed that this could now be called into question.
FOMC minutes will be released later today. After Powell’s bombshell yesterday, these minutes have basically been rendered moot. Still, given the markets leaning these days, we suspect they will be looking to latch onto anything remotely dovish in these minutes.
Note that the market’s dovish take on Fed policy did not start yesterday. Rather, Powell’s comments yesterday were simply the culmination of several dovish signals by senior Fed officials this past month, including those of newly installed Vice Chairman Clarida.
Market expectations for the December FOMC have been largely unaffected, however, with WIRP showing nearly 80% odds of a hike then. The adjustment has been seen further out as the implied yield on the January 2020 Fed Funds futures contract has sunk to 2.69%, the lowest since September 6 and down from a peak near 2.95% on November 8. This current implied yield suggests only one hike in 2019 after the widely expected hike next month.
Markets will be very interested in the December Dot Plots. Will they show any downward movement from the three hikes currently signaled for 2019? Will there be another shift in the longer-term neutral rate? Looking at the dot clusters from September, it would not take much to move either of these down.
Michelle Bowman was recently confirmed as Governor, and so her contribution to the Dot Plots will be new and quite frankly unpredictable. She brings the total number of contributors up to 17. That group is made up of 5 members of the Board of Governors (Powell, Clarida, Quarles, Brainard, Bowman), 5 voting regional Fed Presidents (Williams, Bullard, Evans, George, Rosengren), 4 alternates (Harker, Kaplan, Kashkari, Mester), and 3 non-voters (Barkin, Bostic, Daly). Governor nominees Goodfriend and Liang still need to be confirmed by the Senate before all 19 contributors are fully represented in the Dot Plots.
EVOLUTION OF THE LONGER-TERM NEUTRAL RATE
Note that the latest Dot Plot from September shows the median “longer-term” Fed Funds rate at 3.0%. This median rate has evolved over time. When the first Dot Plot was introduced in January 2012, the median longer-term rate was 4.25%. The median then fell to 4.0% in September 2012, 3.75% in June 2014, 3.5% in September 2015, 3.25% in March 2016, 3.0% in June 2016, and 2.875% in September 2016. After edging back up to 3.0% in December 2016, the median then fell to 2.75% in September 2017. It rose to 2.875% in March 2018 and then to 3% in September 2018.
Not surprisingly, the range of estimates for the longer-term neutral rate has also evolved over time. After starting off in January 2012 at 3.75-4.5%, the range widened to 3.5-4.5% in April 2012 and then to 3.0-4.5% in June 2012. After two more quarters at 3.0-4.5%, the range then narrowed to 3.25-4.5% in March 2013, to 3.25-4.25% in June 2013, and then to 3.5-4.25% in December 2013. After some fluctuation, the range edged down to 3-4% in September 2015 and eventually to 2.5-3.5% in June 2017 and bottoming at 2.25-3.0% in December 2017.
We note that the range of estimates has averaged 1 percentage point since the Dot Plots began. As the graph shows, the Fed Funds rate is indeed moving closer and closer to the range of estimates for the longer-term neutral rate, just as Chairman Powell noted yesterday.
A BRIEF HISTORY LESSON
Back in early October, Fed Chair Powell sounded very hawkish. He noted that “Interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral. We may go past neutral. But we’re a long way from neutral at this point, probably.”
What exactly does the neutral Fed Funds rate represent? As the San Francisco Fed writes, it is “the federal funds rate that neither stimulates (speeds up, like pushing down the gas pedal on a car) nor restrains (slows down, like hitting the brakes) economic growth.” The SF Fed adds that the neutral rate is “often defined as the rate or range of rates consistent with full employment, trend growth, and stable prices. An economy in this state presumably wouldn’t need to be stimulated or slowed by monetary policy.” The neutral rate is often called the “natural” or “equilibrium” interest rate and is represented as r*.
While the neutral rate is easy to define, it is very difficult to calculate. Indeed, most economists accept the fact that the natural rate is not static. As former Fed Chair Yellen put it, “The neutral real rate itself depends on a variety of factors – the stance of fiscal policy, the trend of the global economy which shows up in our net exports, the level of housing prices, the equity markets, the slope of the yield curve, or the term premium built into the yield curve. So it changes over time.”
SHORTER-TERM VS. LONGER-TERM NEUTRAL
Governor Lael Brainard recognizes the distinction between the shorter-term neutral rate and the longer-term neutral rate. In a speech dated September 12, she noted that the shorter-run rate “does not stay fixed, but rather fluctuates along with important changes in economic conditions. For instance, legislation that increases the budget deficit through tax cuts and spending increases can be expected to generate tailwinds to domestic demand and thus to push up the shorter-run neutral interest rate.” Brainard adds that “Estimates suggest the shorter-run neutral rate tends to be cyclical, falling in recessions and rising during expansions, and our current expansion appears to be no exception.”
With regards to the longer-term neutral rate, Brainard notes that past empirical work has yielded many estimates. She wrote that “The central tendency of those estimates suggests that the longer-run trend rate is in the range of 2.5-3.5% in nominal terms. This range lines up well with the most recent median estimate of the longer-run federal funds rate in the FOMC SEP, which is just below 3%. By these estimates, the longer-run neutral rate has fallen considerably from the estimated range in earlier decades of 4-5%.” Brainard goes on to note that the only estimates for a “neutral” rate published by the Fed is the “longer-term” rate that’s contained in the dot plots.
We believe that Brainard’s view largely reflects the consensus outlook at the Fed. Brainard says, “the shorter-run neutral rate, rather than the longer-run federal funds rate, is the relevant benchmark for assessing the near-term path of monetary policy in the presence of headwinds or tailwinds.” In that regard, she goes on to make a very important observation. That is, “The shift from headwinds to tailwinds may be expected to push the shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell below the longer-run equilibrium rate following the financial crisis. Notably, the sizable fiscal stimulus in the pipeline is likely to continue to bolster the short-run neutral rate over the next two years.”
Bottom line: We downplay the significance of Powell’s comments yesterday while acknowledging the potential harm to perceived Fed independence. Recent US economic data suggest markets are now vastly underestimating the Fed’s capacity to tighten. While much depends on the US economic performance in 2019, we think US rates are likely to rise more than what markets are expecting. This is dollar-positive and equity-negative, to state the obvious.
With the median longer-term neutral rate currently at 3.0%, we can make an educated (and frankly conservative) guess that Fed might see the shorter-run neutral rate somewhere near 3.5%. In other words, the market is likely underestimating the terminal Fed Funds rate for this current tightening cycle by upwards of 75 bp, perhaps even more if the Fed feels it has to move to a restrictive policy rate.
Of course, this is all predicated on a continued economic expansion in the US. If the facts change and the economy slows or goes into recession, then the Fed will have no choice but to adjust its expected rate path. But for now, with growth at 3.5% SAAR in Q3 and tracking around 3% SAAR in Q4, the economy can cope with and needs more tightening. Unemployment is at a cycle low 3.7% and is expected to edge even lower even as average hourly earnings picked up to a cycle high 3.1% y/y in October.
Indeed, what makes the dovish market perceptions so strange is that the outlook for the US economy remains constructive. Bloomberg consensus shows US GDP growth remaining above 2% on a SAAR basis until Q1 2020 and above 2% on a y/y basis past Q1 2020. Trend growth for the US is generally accepted to be around 2% post-crisis.
While being dollar-positive, a steeper US rate path than what markets are currently pricing in will be very, very negative for EM. This is especially true for the debtor/deficit countries like South Africa, Turkey, Brazil, India, and many more. On the flip side, the surplus/credit countries like Korea, Singapore, and Taiwan are likely to hold up relatively better.