Janet Yellen and company are discussing the wrong issue. A FED FUNDS rate hike has already taken place due to the increase in LIBOR rates, which has led to a pricing of the December eurodollar futures contract, currently trading at 99.08–an effective six month yield of 92 BASIS POINTS. This due to the Oct. 14 regulatory compliance deadline for money market funds. In order to ensure there’s enough liquidity to protect against unknown outflows, institutional prime funds are shortening the maturities of their commercial paper, CD holdings, pushing up the CP/CD rates and LIBOR with it. Some prime funds have converted to government-only to circumvent the impending regulations, which has created more demand for U.S. Treasuries. (According to the SEC’s July money market report, govt funds had inflows of $77 billion while prime funds saw outflows of $41 billion.) As a result, the TED spread has widened 15 BASIS POINTS during the past two months. The September eurodollar/fed fund futures spread is trading at 53 basis points. WHAT THE FED HAS TO DO IS BEGIN SHRINKING ITS BALANCE SHEET BY 100 BILLION ASSETS A MONTH. Why?
The rationale put forward for a FED rate hike is so the central bank will have room to CUT when the economic indicators reflect a renewed slowdown. At this moment, it is a ridiculous idea since the other major central banks in a high state of liquidity pumping. If the Fed had wanted to be prepared to return to normalcy it would have been when the jobs data began dropping through the original thresholds of 7%. (Remember when the FOMC believed that represented a key level? Then it was 6.5% and the goalposts were kept moving lower.) Just leave the FUNDS rate where it is and shrink the balance sheet because with global interest rates so low the next time the FED has to ease it will be through more QE. Monetary policy at the zero bound has to be far more creative than merely lowering the FUNDS rate.
The FED is terrified of shrinking its balance sheet because of the May/June 2013 market meltdown known as the TAPER TANTRUM. BECAUSE THESE ACADEMICS RELY ON MODELS AND NOT MARKET KNOWLEDGE THEY ARE MISSING A KEY INGREDIENT TO WHY THIS TIME IS DIFFERENT. The ECB, BOJ and BOE are PURCHASING A COMBINED $200 billion per month in assets, providing a strong support system for FED ASSET SALES. $100 billion per month won’t destroy the global bond markets. If the ECB wants to keep pumping liquidity let them be the purchaser of last resort.
1. The 10-year Treasury/bund chart is locked in a very tight range as ECB purchases of sovereign debt make all yields a relative play. Yes, FED selling may put some upward pressure on U.S. long-term yields but it will be minimal because of the BOJ and ECB programs.
2. The FED‘s removal of liquidity from the U.S. banking system will have minimal effect on rates because most of the excess reserves are parked at the FED anyway. The ECB and BOJ have eased the burden of the Fed being the major provider of liquidity.
3. The effect would be a steepening of the U.S. yield curve, which would aid domestic bank earnings and probably increase the desire to make loans.
4. Because many global financial loans are based on LIBOR, after the regulatory impact from the October rule change USD LIBOR rates may fall as short-term lending has some certainty. The DOLLAR may not rise if short-rates stay at its present levels because it is not the long-end that is the key variable for the DOLLAR. The FED needs to lose its fear of the TAPER TANTRUM and do the RIGHT THING. SHRINK THE BALANCE SHEET BEFORE RAISING THE FED FUNDS RATE.
This is just an opinion based on market function rather than models. Proceed on a monthly basis and if I AM WRONG THE SELLING PROGRAM CAN BE CURTAILED. BOJ Governor Kuroda and ECB President Draghi are providing the perfect opportunity for Janet Yellen to take the ROAD LESS TRAVELED. Janet, do not yield to fears of a taper tantrum.
Tags: BOJ, ECB, Fed, Fed Funds, Janet Yellen, Kuroda, LIBOR, Mario Draghi, money market regulation
August 24, 2016 at 4:21 pm |
“THEY ARE MISSING A KEY INGREDIENT”
“The rationale put forward for a FED rate hike is so the central bank will have room to CUT when the economic indicators reflect a renewed slowdown.”
Or perhaps they forgot to take the memo down before leaving on vacation?
August 25, 2016 at 5:06 am |
And why do you think sanity will prevail? Have term limits been established to make the career politician extinct? Have we started restructuring and swapping the debt? Is the rule of law being applied equally or is the establishment, which includes the media, fighting with its last breath to elect a queen of the biggest banana republic on mother earth? How about shrinking the size of govt first? Failing to do so will insure insanity, as the same mistakes keep being repeated, which could lead to another Black Friday – https://www.armstrongeconomics.com/panic-of-1869/.
The Fed will raise only to TRY to salvage their reputation as a serial bubble blower, which of course will do neither.
BTW, anyone see Farage speak at Trump rally? Sure didn’t see it anywhere in the MSM. Wonder why?
August 25, 2016 at 7:36 am |
James Carville (1993) “I want to come back as the bond market. You can intimidate everyone.”
August 25, 2016 at 7:56 am |
This WSJ Op Ed from a former member of the Federal Reserve says it all. 1) Group think 2) Reluctance to cede their power.
By KEVIN WARSH
Aug. 24, 2016
The conduct of monetary policy in recent years has been deeply flawed. U.S. economic growth lags prior recoveries, falling short of forecasts and deteriorating in the most recent quarters. This week in Jackson Hole, Wyo., the Federal Reserve Bank of Kansas City hosts the world’s leading central bankers and academics to consider monetary reform. The task is timely and consequential, but the Fed needs a broader reform agenda.
Policy makers around the world neither predicted nor can adequately explain the reasons for current inflation readings below their targets. So it is puzzling that so many academics are pushing to raise the current 2% inflation target to a higher target of 3% or 4%. In the telling of the economics guild, the Fed’s leaders should descend from the Grand Tetons with supreme assurance that their latest monetary policy invention will remedy the economy’s ills.
The Fed’s leaders should not take the bait. Raising the inflation target is a bad idea being considered at the wrong time for the wrong reasons.
A new inflation target would undermine the Fed’s commitment to any policy framework. It would please the denizens of Wall Street who pine for still-looser Fed policy. And households would be understandably miffed to receive a new lecture on unconventional monetary policy—this one on the benefits of higher prices.
A change in inflation targets would also add to the growing list of excuses that rationalize the economic malaise: the persistent headwinds from the crisis of the prior decade, the high-sounding slogan of “secular stagnation,” and the convenient recent alibi of Brexit.
A numeric change in the inflation target isn’t real reform. It serves more as subterfuge to distract from monetary, regulatory and fiscal errors. A robust reform agenda requires more rigorous review of recent policy choices and significant changes in the Fed’s tools, strategies, communications and governance.
Two major obstacles must be overcome: groupthink within the academic economics guild, and the reluctance of central bankers to cede their new power.
First, the economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.
The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality.
The Fed often treats financial markets as a beast to be tamed, a cub to be coddled, or a market to be manipulated. It appears in thrall to financial markets, and financial markets are in thrall to the Fed, but only one will get the last word. A simple, troubling fact: From the beginning of 2008 to the present, more than half of the increase in the value of the S&P 500 occurred on the day of Federal Open Market Committee decisions.
The groupthink gathers adherents even as its successes become harder to find. The guild tightens its grip when it should open its mind to new data sources, new analytics, new economic models, new communication strategies, and a new paradigm for policy.
The second obstacle to real reform is no less challenging. Real reform should reverse the trend that makes the Fed a general purpose agency of government. Many guild members believe that central bankers—nonpartisan, high-minded experts—are particularly well-suited to expand their policy remit. They fail to recognize that central bank power is permissible in a democracy only when its scope is limited, its track record strong, and its accountability assured.
The Fed is suffering from a marked downturn in public support. Citizens are rightly concerned about the concentration of economic power at the central bank. Long after the financial crisis, the Fed holds trillions of dollars of assets that would otherwise be in private hands. And it appears to make monetary policy with the purpose of managing financial asset prices, including bolstering the share prices of public companies.
With the enactment of the Dodd-Frank Act, the Fed claims the mantle of reform. It now micromanages big banks and effectively caps their rate of return. The biggest banks’ growth in market share corresponds to that of their principal regulator. They are joint-venture partners with the Fed, serving as quasi-public utilities. As the dispenser of fault and favor, the Fed is contributing to the public perception of an unfair, inequitable economic system. Real reform this is not.
Most gathered in Jackson Hole will judge that the Fed’s aggressive actions are necessary and wise. Even if that were true, the Fed finds itself in an increasingly untenable position. Congress will tag the Fed for its failures, and the public will assail the Fed for favoritism for its ostensible successes.
In the best of circumstances, the U.S. economy will accelerate to “escape velocity.” In that event the Fed might get the benefit of the public doubt.
If, as is more likely, the economy is closer to recession than resurgence, the Fed is poorly positioned to respond with force, efficacy and credibility. The Fed is vulnerable. Its recent centennial as our nation’s central bank should not be confused with its permanent acceptance in the American political system.
Mr. Warsh, a former member of the Federal Reserve board, is a distinguished visiting fellow in economics at Stanford University’s Hoover Institution.
August 25, 2016 at 8:34 am |
this was agreat piece—everybody should read and also the recent piece by Carmen Reinhart—thanks Frank for posting
August 25, 2016 at 2:03 pm
“escape velocity” in the best of circumstances….. Consistently managing expectations lower.
August 25, 2016 at 2:07 pm
Here is a friend of Janet’s calling out the Fed’s Missteps.
The writer WSJ’s John Hilsenrath has not only been very supportive in the past, but is considered a Yellen insider/ mouthpiece.
It appears that the drumbeat of dissatisfaction and distrust with the Fed is becoming louder. The Fed is rated lower than the IRS.
( I would normally post only a link; but some may not have subscriptions to the WSJ and thus only get a byline.)
THE GREAT UNRAVELING
Years of Fed Missteps Fueled Disillusion With the Economy and Washington
Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions
By Jon Hilsenrath
In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal. In response they engineered unpopular financial rescues, launched start-and-stop bond buying and delayed planned interest-rate boosts.
“There are a lot of things that we thought we knew that haven’t turned out quite as we expected,” said Eric Rosengren, president of the Federal Reserve Bank of Boston. “The economy and financial markets are not as stable as we previously assumed.”
In the 1990s, a period known in economics as the “Great Moderation,” it seemed the Fed could do no wrong. Policy makers and voters saw it as a machine, with buttons officials could push to heat or cool the economy as needed. Now, after more than a decade of economic disappointment, the central bank confronts hardened public skepticism and growing self-doubt about its own understanding of how the U.S. economy works.
For anyone seeking to explain one of the most unpredictable political seasons in modern history, with the rise of Donald Trump and Bernie Sanders, a prime suspect is public dismay in institutions guiding the economy and government. The Fed in particular is a case study in how the conventional wisdom of the late 1990s on a wide range of economic issues, including trade, technology and central banking, has since slowly unraveled.
Once admired globally for their command of the economic system, central bankers now are blamed by the left and right for bailouts during the financial crisis and for failing to foresee and manage forces suffocating the global economy in its aftermath.
Populist protest movements called “Fed Up,” “End the Fed” and “Occupy Wall Street” lashed out at the bank’s policies, and in the case of End the Fed, its very existence. Lawmakers of both parties want to subject it to more scrutiny or curb its powers.
How Americans rate federal agencies
Share of respondents who said each agency was doing either a ‘good’ or ‘excellent’ job, for the eight agencies for which consistent numbers were available
Source: Gallup telephone polls, most recently 1,020 U.S. adults conducted Nov. 11–12, 2014, with a margin of error of +/-4 percentage points
Source: Gallup telephone polls, most recently 1,020 U.S. adults conducted Nov. 11–12, 2014, with a margin of error of +/-4 percentage points
David Einhorn, founder of the hedge fund Greenlight Capital, cites the fable of the ant and the grasshopper, in which a famished grasshopper begs a thrifty ant for help in wintertime after failing to stockpile food during warmer weather.
“We had the grasshoppers party from 2002 to 2007 and winter came and the Fed bailed them out,” said Mr. Einhorn, referring to financial firms and individuals who lived above their means. “Now the ants are pissed.”
The Fed’s struggles will be on display from Friday to Sunday when it gathers for an annual retreat in Jackson Hole, Wyo. On issues of growth, inflation, interest rates, unemployment and how to fight a recession, basic assumptions inside the central bank’s complex computer models have been upended.
“I certainly myself couldn’t have imagined six, seven years ago that we would be employing the policies we are now,” Fed Chairwoman Janet Yellen said to a packed ballroom in New York earlier this year. She lamented the government has leaned so heavily on the Fed to stimulate the economy while tax and spending policies were stymied by disagreements between Congress and the White House.
Many Fed officials believe—and private economists agree—their responses to the crisis helped avert a second Depression, outweighing any unfairness in the bailout process. Fed leaders believe low rates helped, too. “Inflation would be lower and unemployment higher now by noticeable amounts had we not employed those policies,” Ms. Yellen said in March.
Regardless, confidence in the central bank’s leadership has dropped. An April Gallup poll found 38% of Americans had a great deal or fair amount of confidence in Ms. Yellen, while 35% had little or none. In the early 2000s, confidence in Chairman Alan Greenspan often exceeded 70%.
How confidence in the Fed leader has shifted
How much confidence do you have that the Fed leader will do the right thing for the economy?
Note: Percentages may not total 100 due to rounding. Source: Gallup telephone polls, most recently of 1,015 U.S. adults conducted April 6–10, 2016, with a margin of error of +/-4 percentage points
Note: Percentages may not total 100 due to rounding. Source: Gallup telephone polls, most recently of 1,015 U.S. adults conducted April 6–10, 2016, with a margin of error of +/-4 percentage points
The Fed’s own uncertainty about the economy’s underpinnings is more than a decade in the making and traces back to three key developments that have thrown officials for a loop.
A Wall Street Journal series examining the causes and consequences of 2016’s political upheaval
Election 2016 Is Propelled by the American Economy’s Failed Promises (7/7/16)
How the China Shock, Deep and Swift, Spurred the Rise of Trump (8/11/16)
First, officials missed signs that a more complex financial system had become vulnerable to financial bubbles, and bubbles had become a growing threat in a low-interest-rate world.
Secondly, they were blinded to a long-running slowdown in the growth of worker productivity, or output per hour of labor, which has limited how fast the economy could grow since 2004.
Thirdly, inflation hasn’t responded to the ups and downs of the job market in the way the Fed expected.
The shifting financial, productivity and inflation scenarios made it hard to gauge where interest rates belonged even before the financial crisis and are central to Ms. Yellen’s dilemmas today.
She is trying to raise short-term rates, but the economy so far has proved too feeble to absorb more than one small increase from near zero last December. If she waits too long before moving again, she could encourage bubbles. If she raises rates too much, she could cut off a fragile expansion and, in a replay of Japan’s experience, never drive inflation to the Fed’s target of 2%.
“Unfortunately, all economic projections are certain to turn out to be inaccurate in some respects, and possibly significantly so,” Ms. Yellen warned in a June speech. “The uncertainties are sizable.”
How often the Fed’s economic projections missed the mark, and by how much
*Fed estimates reflect the midpoint of central tendency of estimates included in the Fed leader’s twice-annual report to Congress. Central tendency is the range of Federal Open Market Committee participants’ estimates, excluding the three highest and the three lowest. Some periods have more estimates than others, based on how many years into the future the Fed forecast at the time. Estimates have been compared to the most recent reported actual value for each period. The Fed measures both inflation and GDP based on the fourth quarter value’s change from the same quarter a year earlier. Sources: Federal Reserve (forecasts); Commerce Department (actual inflation and GDP)
One window into the Fed’s run of misjudgments is a computer model it uses to calibrate how the economy is likely to respond to changes in interest rates and outside shocks. It is called FRB/US, known as “Ferbus.”
Simulations the Fed did with FRB/US during debates about a possible housing bubble in 2005 and again in 2007 failed to show how a fall in home prices would ripple through the financial sector, freezing credit that was the lifeblood of the economy.
“Assuming that the FRB/US model does a good job of capturing the macroeconomic implications of declining house prices, such an event does not pose a particularly difficult challenge for monetary policy,” John Williams, then a Fed analyst and now president of the San Francisco Fed, said during a debate on the housing boom in 2005.
The model showed the economy could weather a 20% drop in home prices with small increases in unemployment and modest cuts in interest rates.
Ferbus didn’t account for the damage that unstable financial institutions can do to an economy. Unemployment rose to 10%, the Fed cut rates to near zero and then launched programs that ballooned its securities portfolio to more than $4 trillion.
San Francisco Fed President John Williams said that before the financial crisis, Fed models lacked a full grasp of how much risk and leverage had grown in the financial system. Mr. Williams is seen in his office in September 2015.
San Francisco Fed President John Williams said that before the financial crisis, Fed models lacked a full grasp of how much risk and leverage had grown in the financial system. Mr. Williams is seen in his office in September 2015. PHOTO: JASON HENRY FOR THE WALL STREET JOURNAL
“What was missing to me was the in-depth understanding of how much risk and leverage had grown in the financial system and basically how lacking in resilience the financial system as a whole was to this kind of shock,” Mr. Williams said in a recent interview.
Fed officials say they are alert to the financial system’s risks and have cushioned it by forcing banks to hold more capital. Other entities, such as hedge funds and money-market funds, are more closely watched.
Still, some worry that even with those efforts, continuing very low rates could feed instability by driving investors too heavily into some asset class in search of higher returns.
Mr. Rosengren is worried about booming commercial real estate. “You do have to think about some of the collateral effects that can occur when interest rates are low for a long period,” he said. “Real estate is one of those sectors.”
Richard Fisher, former president of the Dallas Fed, said low interest rates are adding to discontent by forcing consumers to save more to meet their nest-egg needs. The unintended message households get from low rates, he said, is “you’re going to have to save a hell of a lot more before you consume.”
Fed models didn’t pick up on a broader economic slowdown already in train by 2004 because the people running the models also didn’t recognize productivity growth was entering an extended slowdown.
In the long run, an economy can expand only at a rate sustained by the growth of its labor force and the productivity of its workers. During the 1990s, output per hour surged, in part because companies poured money into new technologies and machinery. Many economists assumed the high-tech economy would keep fueling rapid productivity growth, but it didn’t, for reasons economists still don’t fully understand.
In the decade from 1994 to 2003, U.S. output per hour worked rose annually by an average 2.8%. Since then it has grown at 1.3%, including just 0.4% since 2011.
Boston Fed President Eric Rosengren and Fed Chairwoman Janet Yellen in October 2014 in Chelsea, Mass., where Ms. Yellen spoke with residents of the economically hard-hit area.
Boston Fed President Eric Rosengren and Fed Chairwoman Janet Yellen in October 2014 in Chelsea, Mass., where Ms. Yellen spoke with residents of the economically hard-hit area. PHOTO: DOMINICK REUTER/REUTERS
Fed officials, failing to see the persistence of this change, have repeatedly overestimated how fast the economy would grow. The Fed has projected faster growth than the economy delivered in 13 of the past 15 years and is on track to do so again this year.
Private economists, too, have been baffled by these developments. But Fed miscalculations have consequences, contributing to start-and-stop policies since the crisis. Officials ended bond-buying programs, thinking the economy was picking up, then restarted them when it didn’t and inflation drifted lower. Its shifts became a source of uncertainty in financial markets.
A slow-growing economy can’t bear high interest rates, and so the Fed also hasn’t delivered as many rate increases as it said it planned. In June 2015, officials estimated their benchmark short-term rate would exceed 1.5% by the end of this year. It remains below 0.5%.
“They have held out the prospect of tighter money, and that has had a discouraging effect on demand to a greater extent than would have been ideal,” said Lawrence Summers, a Harvard professor and former Treasury Secretary. “They have lost credibility by constantly predicting tightening that, out of prudence, they didn’t deliver.”
For years after the financial crisis, officials attributed slow growth to temporary headwinds, such as banks’ unwillingness to lend. Now they are coming to think the productivity slowdown is the root of the problem, and might not go away.
For James Bullard, president of the St. Louis Fed, uncertainty about the long-run growth and rate outlook led to an about-face.
Fed officials regularly project where they think rates are heading over the longer run. The projection is a signal to the public of how monetary policy is expected to evolve over several years. Unsure about how the economy is behaving and what it means for rates, Mr. Bullard scrapped his forecast altogether.
“We are backing off the idea that we have dogmatic certainty about where the U.S. economy is headed in the medium and longer run,” he said in a paper in June.
Inflation is the third ingredient in the Fed’s self-doubt. For years it has been largely unresponsive to the ups and downs of unemployment, defying the conventional view that inflation rises when unemployment falls, and vice versa. Unemployment surged during the financial crisis, but inflation didn’t fall much, as Fed models suggested it should. And when joblessness fell, inflation didn’t move up much, either.
In offices adjacent to Ms. Yellen, two Fed governors, Lael Brainard and Daniel Tarullo, are lobbying against interest-rate increases because they aren’t convinced by models suggesting inflation will eventually rise.
“Inflation is not at our stated target, not near our stated target, and hasn’t been so in quite some time,” Mr. Tarullo said in a June interview.
Still looming is potentially the biggest reversal of all in the modern conventions of central banking. If another recession hits, it isn’t clear the Fed has the tools available to mend the economy, a subject Ms. Yellen could address in Jackson Hole.
Traditionally the Fed cuts interest rates in a downturn. With its benchmark short-term rate near zero, it can’t be pushed much lower. If recession hits, the Fed will likely resort to unpopular tools used after the financial crisis, including Treasury-bond purchases and more promises to keep short-term rates low far into the future.
“We should be extremely worried,” Mr. Summers said. “We are essentially on a fairly dangerous battlefield with very little ammunition.”
August 25, 2016 at 9:56 pm
Perhaps the Dollar General CEO can provide some color on where consumers are being squeezed.
August 25, 2016 at 1:15 pm |
Yra, I used to think much the same but the write-ups by Zoltan Pozsar and co at Credit Suisse have changed my mind. In this new post-Basel III world with Liquidity Coverage Ratios and High Quality Liquid Asset needs, it might not be so easy/desirable to shrink those reserves. Hey, I think he might have a point that a small Fed balance sheet was odd, not a big one. Sadly, I think the only tools in the Feds’ toolbox at this point are rate changes and forward guidance (thus all the jawboning). Trade accordingly.
August 25, 2016 at 4:21 pm |
Dan—points are well taken and Zoltan Pozsar recent piece was good but read Richard Koo who also maintains if the Fed doesn’t shrink that balance sheet there will be trouble ahead if the economy gets to escape velocity
August 26, 2016 at 7:05 am |
Inflation… When 2% is not enough | The Economist
http://www.economist.com/news/leaders/21705826-rich-worlds-central-banks-need-new-target-when-2-not-enough?fsrc=scn/tw/te/pe/ed/
August 26, 2016 at 7:36 am |
Arthur–thanks for posting this link—good article