The Monetary Divergence
The Federal Reserve, as widely expected, announced on March the 15th that it intends to raise interest rate to 0.75% to 1%, up from the 0.5% to 0.75% range set in December 2016. This is the third rate hike from the FED since the financial crisis. The Federal Open Market Committee (the FOMC, the interest rate-setting body within the Fed) projected two more rate hikes in 2017, unchanged from its prior estimate. The reason behind the hikes, according to the FED officials, would be to begin a tightening cycle this year as the U.S. economy seems to approach full employment. This seems quite extraordinary if we consider that by means of those monetary policies the U.S. economy is dissociating from the rest of the world. Expansionary and accommodating monetary policies are still being applied by many other advanced economies almost 10 years after the crisis. For instance, the ECB and the Bank of Japan are engaged in huge ongoing asset purchase programs, with negative interest rates in Japan, Eurozone, Switzerland and Sweden. Unprecedented in almost two decades, we are experiencing a significant divergence between Europe and the US.
From Figure 1 we can notice that the U.S. has been for a long time the leading country concerning monetary policy: in fact, we see that in 2001 the FED eased monetary conditions with other economies tending to catch up with a lag of up to one year. The tightening cycle in 2006 or the easing during the financial crisis immediately after follow the same pattern.
A glimpse of why the FED can be consider being a monetary superpower comes from this key chart from the working paper from Ethan Ilzetzki, Carmen Reinhart, and Kenneth Rogoff. Figure 2 clearly shows that 70% of world GDP has its monetary policy effectively set by the US central bank. These numbers provide clues that it is probable that the FED influence on other global currencies is even larger.
This brief explanation on the role of the Dollar and the FED in the global markets is necessary to understand how out of the norm is the divergence between monetary policies in the US and Europe, the first decoupling in over two decades. This can be considered the main monetary event of the years to come. FED’ s tightening cycle is ongoing, with short-term interest rates maybe approaching 2% by the end of 2017, while interest rates could remain below zero in Europe and Japan for the next few years, because of the weakness of aggregate demand in the Eurozone that haven’ t yet disappeared.
What’ s Behind the Last Rate Hike?
The FED has raised interest rates three times since the financial crisis (highlighted in yellow in Figure 3). Here we see the new lag up breaking out through resistance at 1.30% right before the last FOMC meeting of the 15th of March 2017, that drags the third yellow circle above the trend. Considering the first two yellow circles and their first derivative, we can feel FED’ s urgency to get going when we look at the slight acceleration up to the third yellow circle.
What about the future? The FED, in its publications give us some clue about what its policy makers think is coming in the future. The “dots plot” shows the projections of the 16 members of the Federal Open Market Committee. It is part of the FOMC’s Summary of Economic Projections released together with the policy decision statement. It shows where each participant in the meeting thinks the fed funds rate (its range, not level) should be the next few years and in the longer run. It provides an insight into into what the Fed is thinking about future economic and monetary conditions and it is highly vaulted by investors. Important is the direction of the movement: investors want to know whether the FOMC is about to engage a loose monetary policy, reducing rates, or tight policy, raising rates.
In the longer term, the FED expects a gradual schedule of hikes year after year, until interest rates eventually settle around 3% (Figure 4).
This projections are confirmed by Figure 5: this is how much room the FED has to pick up with the Taylor Rule.
Taylor Rule is an equation that relates inflation rate and unemployment rate (the two main targets of a central bank’ s mandate) and it is the monetary rule that the FED has always been following during the years. It signals to the monetary authorities divergences with respect to economic growth and price fluctuations and it calculates what the Federal Funds Rate should be, as a function of the output gap and current inflation. Basically, when for instance the economy recovers (with low unemployment rate) and inflation raises, then the Taylor Rule suggests central bankers to raise interest rates (the Effective Federal Funds Rate for the US). From the chart below we can notice how the Taylor Rule has always been followed by the FED.
The basic monetary Taylor Rule formula look like this:
i = r° + π + 0.5*(π-π°) + 0.5*(y-y°)
i = nominal FED Funds Rate
r° = real Federal Funds Rate (usually 2% at the steady state according to Taylor)
π = current rate of inflation
π° = target inflation rate
y = logarithm of current real output
y° = logarithm of potential output & (y-y*) is the output gap
This equation underlying significance is that the difference between nominal and real interest rate is inflation. We are determining at possible targets of interest rates by looking at the total picture of an economy in terms of prices. The rule states that the real interest rate should be 1.5 times the inflation rate. Consumer Price Index, Producer Prices and the Employment Index are the three things central bankers usually look at when calculating prices and inflation in the Taylor Rule. We look at this formula also with respect to the coefficients on the deviation of real (actual) GDP from trend (target) GDP, that is the so-called output gap. Productivity, Employment Rate and its changes give us the total output of an economy. In order to calculate inflation and price levels, a moving average of the various price levels is usually applied to determine some kind of trend and ensure little price fluctuations, performing the same on the monthly interest rate data.
An usual estimation of the Taylor Neutral Rule Estimate is given by the formula:
i = r° + π + [α*(π-π°)] + [β*factor*(NAIRU-Unemp)]
with coefficients, for instance r°(real rate)=1%, pi(inflation=Core PCI)=1.74, pi°(target)=2%, α=0.5, β=0.5, NAIRU=4.20, Unemp=4.70 which give a Taylor estimate of 2.11%. We can also calculate:
Adjustment for policy inertia = [ρ*prev FED rate]+[(1-ρ)*i]
with coefficients i=2.11%, pref FED rate(=last quarter’s actual value)=0.75%, ρ=0.8 (based on historical data, estimates of ρ are often in the range of 0.8, implying a slow speed of adjustment—about 20% per quarter—of the policy rate to its fundamentals). Such adjustment implies that the FED distributes desired changes in the policy interest rate over time and indicates the persistence of the policy rate to the fluctuations of macroeconomic fundamentals, such as inflation and output.
In the graph below the following Taylor Rule framework has been used:
i = (2%) + π + [0.5 (π-(2%))]+ [0.5 (y-y°)/y°*(100)]
Inflation is measured by changes in the CPI, and we use a target inflation rate of 2%. We also assume a steady-state real interest rate of 2%. Output gap is measured as the difference between potential output (published by the Congressional Budget Office) and real GDP.
in Figure 5 the red line represents the FED Fund Target Rate an the blue line is the Taylor Estimate above. We used the dots plot to get a clue of the recovering of the interest rates to the Taylor Rule up to 2019 and in the longer term and what is extraordinary is that the Taylor Rule is going to be above the interest rate red line for other 2 or 3 years. We can see form Figure 5 that the blue line has been almost always below the red line with things changing in proximity of the circle: this represents how much the FED is behind the Taylor Rule. It has been so since 2011/2012, after a period in which the rule has been extremely accommodative and davish, below zero. After that period, it reverted above zero pretty linearly with the FED lagging behind and keeping interest rates low. The distance apart is a lot.
Why the FED has been so cautious in rising rates and why some investors and economists are concerned about the fact it may be instead too early to increase rates probably three times by the end of this year?
What the FED and generally other Central Banks surely do not want to replicate is the red spot in the following graph (Figure 6):
The Uncollateralized Call Rate was lowered to zero at the beginning of 1999. The Bank of Japan raised the call rate to 0.25% in August 2000 in illusion of extended economic expansion, incurring in protests from the government and market analysts. An additional measure of quantitative easing was required and the interest rate was lowered to zero again in March 2001. They raised rates and they failed. This is the core memory of every central banker, Yellen included, who, says some economists, need to be cautious in raising rates prematurely.
Dovish Rate Rise and Market Reactions
Here’ s what has happened to the yield curve in the US (Figure 7): in proximity with the US elections the curve is steepening, with the difference in the yield between the 2 years and the 10 years yields of treasury bills growing. One might think that the FED recent enthusiasm would drive to a steeper yield curve, but what is happening is pretty significant: the short and the long term rates both came up together, one following the other, so that we have a curve that slightly flattens. That’ s indeed really worth noticing because it means that the whole rate regime is moving up with that enthusiasm. Recently, after the third hike, the curve has been starting to decline a little bit. Why is that important? A flat or inverted yield curve often has led to a recession and crash in the stock market (as it did prior 2000 and 2008). In fact, the FED has already experienced cycles between lowering rates too much, causing a steepening yield curve, then rising rates too quickly and flattening it out, which many analysts think is the case.
Many rate hikes, the last of which was mostly anticipated by financial markets and was thus priced in, are expected to reach gradually a level of 3% in 2019. Surprising was particularly the financial markets’ reaction: the dollar depreciated against the euro by almost 1% in the immediate aftermath. U.S. stock markets were up (half a percent) as well because of the signal Wall Street is receiving from the FED. In short: the economy is doing just fine. Both 2 year and 10 year U.S. Treasury Bills decreased by almost 10 basis points, so that the entire yield curve shifted down by a bit (Figure 5). The FED made it clear that the tightening cycle will be gradually engaged, with another two rate hikes before the end of 2017, but still financial markets seem to discount the idea that the FED might tighten monetary policy rapidly. In fact, ironically, the unintentional easing of financial conditions by the FED registered by those market prices might indeed increase the probability of next future rate hikes. If FED officials are right, the US economy is currently close to full employment levels, meaning there shall be no urgency to stimulate economic growth further. Thus the FED might decide to increase rates three or more times depending on economic conditions.
Inflation and Labour Market
We have seen how the FED wants to raise rates in the hopes of keeping the economy from “overheating“. Are the future rate rises in sight somehow premature? One can argue about whether the U.S. economy has already approached full employment or not, and according to FOMC’s Summary of Economic Projections it almost has. The U.S. economy has performed reasonably well over the last year with a steady GDP growth, a labour market approaching full employment and a forecasted inflation rate on target at 2%.
From Figure 11 we can see the evolution of wage growth through the last two decades, throughout the recessions 2000 and 2008. Here we notice the “nirvana” of the 90’s with wage growth at 5%. After 2008 they fall off the cliff and they don’ t recover until the final lift final in the last months. Yellen’ s hope is that re-bounce in wage growth, suggesting a strengthening labour market, is happening consistently and quickly enough so that to justify a gradual path through removing policy accommodation as the economy makes progress moving toward neutral. In fact, an acceleration in wage growth would mean that the employment is about hit its maximum sustainable level.
But the FED knows it must be cautious and seems to accelerating the number and magnitude of rate hikes in the foreseeable future to prevent the economy from overheating. If this occurs, in fact, conventionally the inflation rate has to be reduced to more acceptable levels, enduring a difficult recessionary period during which the unemployment rate exceeds the natural rate, just what has happened in the 2000 in Japan. The main obstacle for monetary policy is the measurement of the natural rate of unemployment itself. If we would be able to measure the natural rate with certainty, the FED would have clear ideas, so that if the unemployment rate fell below the natural rate, the Federal Reserve would engage a restrictive policy; if the unemployment rate rose above the natural rate, the FED would start an expansionary policy. Unfortunately, the natural rate cannot be known with certainty and therefore must be estimated. Problem is that there are as many different natural rate’ s estimates as there are different econometric models to estimate it.