FOMC Funk

Long-term rates recently crawled up. On rising long-term rates, there are two theories.

In the first, they signal an improved economic outlook, which leads investors to anticipate a swifter hike in rates.

In the second, they are rising because of a change in investor expectations of a swifter rise in rates, independent of economic conditions.

A swifter rise in rates is expected. According to recent views of FOMC members:

Chairman Jerome Powell

April 6, Chicago

“As long as the economy continues broadly on its current path, further gradual increases in the federal-funds rate will best promote these goals.”

Governor Lael Brainard

April 20, CNBC interview

“The outlook looks consistent to me with continued gradual increases in the federal-funds rate.”

New York Fed President William Dudley

April 16, CNBC interview

“I don’t think we know exactly how many more rate hikes we’re going to do this year…Three or four seemed like a reasonable expectation” for 2018 based on what the Fed said in March.

San Francisco Fed President John Williams

April 6, Santa Rosa, Calif.

The Fed’s outlook for three to four rate rises this year followed by further gradual rate increases “is the right direction.” Raising rates “will keep things on an even footing and reduce the risk of us getting to a point where the economy could overheat, and create problems that could end badly.”

As Williams says explicitly, and the others imply, they are worried about the economy overheating, which would bring forth rising/high inflation.

According to the Fed view, therefore, long-term rates rose because of an improved economic outlook, consistent with higher real growth and inflation.

What is, however, the market´s view? That´s not directly observable. In addition, the market´s view can change abruptly. The fact that long rates went over the 3% ‘barrier’, but turned back below rather quickly, may indicate that the market is ‘unsure’.

While the Fed clings (and acts) according to strongly held beliefs, the market is much less assertive.

The Fed strongly believes in the ‘gap model of inflation’ (‘gaps’ include the ‘unemployment gap’, the ‘interest rate gap’, or the ‘real output gap’). These ‘gaps’ are close cousins. Here I concentrate on the ‘real output gap’, the difference between actual and potential output.

Why does Williams think the economy risks ‘overheating’?

The chart explains his ‘belief’. After many years languishing below, even well below, ‘potential’, the economy is back to ‘potential’. More recently, however, it shows signs of growing above ‘potential’, and to the FOMC, that will stoke inflation…

If that were the only ‘evidence’ you are presented, you might agree with Williams (and the FOMC). More evidence, however, is readily available, and they throw a monkey-wrench into the ‘overheating fear’. [Note: All GDP variables indexed to 100 in Q1 1987]

The next chart shows that ‘potential’ was revised down systematically after 2007, (so as not to clutter the charts, only initial and latest ‘potential’ vintages shown) until it converged to actual. Note that backward revisions were small.

The 1990s and first half of the 2000s show the opposite. The economy was working above, sometimes for extended periods, ‘potential’. According to the latest (2007) vintage, ‘potential’ had converged to actual output. At that point, the economy risked ‘overheating’. We know what happened!

The next chart shows that over the period, ‘potential’ was revised up systematically, until it converged to actual…Again, the past was little revised.

Just looking at the pre-2007 period, ignoring ‘potential’ revisions, we would think inflation would be on a rising trend. Quite the contrary is true. Inflation was initially on a downtrend and then remained low and stable. Maybe the absence of rising inflation is behind the constant upward revisions in ‘potential’ for the period.

For the post 2007 period, we would think, also ignoring ‘potential’ revisions that inflation would be falling, even turning into deflation. However, barring an inflation ‘choke’ during the ‘darkest hours’ of the crisis, inflation remained low (maybe too low relative to the target) and stable. Again, this lack of falling inflation ‘indicated’ that output was never far from ‘potential’, so ‘potential’ was revised down.

By subscribing to a misleading theory, Fed mistakes have been costly. The cost, in fact has been large and permanent. Compare, for example two yield curves. One for the day before the world ‘changed’ when Paribas closed two funds for redemption on August 9 2007 and another for April 24 2018.

In both instances, the 10-year – 2-year yield spread is the same. The levels of the yield curves, however, are markedly different, with the most recent yield curve level reflecting the depressed level of real output.

The recent flattening of the yield curve has been driven by the rise in the short end being stronger than in the long end. Given Fed policy, this will likely continue. At some point, the yield curve will invert…

The result will be a deeper depression…and still no inflation.

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