Seven years after the Fed unleashed ZIRP and QE to "fix the economy", it has finally admitted that ZIRP and QE failed to do that (although they certainly succeeded in blowing the biggest asset bubble ever), and for the past 6 months the Fed has engaged in what may be the most ridiculous case of revisionist history, as the narrative has been flipped on its head, and now the all too wise career economists of the Fed (with the help of a few good ex-Goldman bankers) are pitching the first rate hike in nearly a decade as the solution to all the economy's problems.
For now the equity market has played along with this grotesque flip-flop in monetary policy, first by rising two months ago on terrible job numbers which made the December rate hike less realistic, and then rising some more in the aftermath of the October "hawkish" Fed announcement and minutes, which in no uncertain terms warned a December rate hike is coming after all, poor economic data be damned.
To be sure, while stocks as usual remain stuck in their imaginary ivory tower where good news is great, and bad news is even greater, other assets have been far less enthusiastic. In fact, as we have shown repeatedly, the dramatic flattening of the yield curve (via the 2s30s) is now screaming policy error.
Yet if bonds foresee a major monetary policy "error" why do stocks remain oblivious? One attempt at an answer was provided by Goldman late last week when the firm suggested that the natural rate of the economy (to which the Fed will hike rates before re-easing) has declined and will remain lower for longer: in other words, the Fed's experiment has weakened the economy so much, its potential growth rate has been cut in half in the past decade.
To Goldman this was, as can be expected, bullish for stocks and bearish for bonds (ironically even as another part of Goldman is saying that the "Bernanke put" is now gone and has been replaced with the "Yellen call", which is why Goldman's 2016 year end target is an unchanged market).
Another, far more credible interpretation, comes from Deutsche Bank's Dominic Konstam.
According to the DB strategist, what the Fed is likely ignoring is that after decades of bubbles, the monetary excess aftermath of the great financial crisis has still not cleared, and that not only is the equilibrium real rate "lower for longer", it is in fact negative.
What this means is that the Fed, in its reflexive attempt to boost confidence in the economy - and the logic goes as follows: "look, we are raising rates, and we wouldn't be raising rates unless we thought the economy could handle it" (just please ignore the whole "subprime is contained" thing) - is not only engaging in massive policy error, but is about to unleash a recession which will promptly force it to cut rates again (to negative) and start another episode of QE.
Here is Deutsche, first laying out what the Fed economists think:
The real case for policy error - equilibrium short real rates may be below zeroThere are two interpretations of the macroeconomic data that have vastly different implications for the effect of imminent rate hikes. The first is the “conventional” view, which the Fed subscribes to. This view posits that the short-term real equilibrium rate is around zero. Since the nominal Funds rate is at the zero lower bound, policy is accommodative, and this is why the labor market has improved rapidly. Inflation has not picked up because it as a lagging indicator. However, some form of a Phillips Curve relationship does exist, and so inflation will eventually reach the Fed’s 2 percent target. As per this view, if inflation rises and nominal growth also rises then the equilibrium nominal rate will rise. Even if the equilibrium real rate does not change, the Fed might at least be able to get to the market’s view of the terminal rate – slightly below 2 ½ percent – without inflicting serious damage on the economy. If the equilibrium real rate does rise, all the better – the markets would move to the Fed’s dots, and the terminal rate would be around the Fed’s target of 3 ½ percent.
How to determine if the equilibrium rate is negative? Just look at the debt, stupid:
The alternative view is more worrying. In this view, the equilibrium nominal rate is at present much lower than the Fed thinks and the equilibrium real rate is meaningfully negative. Policy at present is not very accommodative, and to the extent that it is, inflation is actually running above its equilibrium level, which is close to 1 percent. One might argue for low “implied” equilibrium short rates via debt ratios. For example, if nominal growth is 3 percent and the debt GDP ratio is 300 percent, the implied equilibrium nominal rates is around 1 percent. This is because at 1% rates, 100% of GDP growth is necessary to service interest costs.
Which goes back to our fundamental thesis from day 1: there is simply too much debt, and while unconventional policy merely increases the debt, the interest rate shock from a rate hike will crash the economy: hence, the Fed is trapped.
In this case, real growth would slow in response to rate hikes because productivity would stay weak at full employment and companies would be profit/price constrained around paying higher wages. Moreover, nominal growth would then slow even more than real growth does because inflation would fall to 1 percent or below.
But... a 25 bps rate hike is tiny: surely the economy can handle it? Actually, if the equilibrium rate is negative, it can't.
This is the important policy error scenario because even a very shallow path of rate hikes might drive the real Funds rate well above the short-term equilibrium real rate, further depressing demand. It is then plausible that the economy would be driven into recession, and the Fed would quickly be forced to abort the hiking cycle. As an aside, such a policy error could reinforce itself by causing structural damage that puts additional downward pressure on the equilibrium real rate. In this case the yield curve would flatten meaningfully, at least until the Fed actually reversed course by cutting rates.
Finally, this is critical because just like Japan in 2000, and all other central banks during the New Normal, who raised rates only to lower them immediately after, the Fed is about to unleash not only a policy mistake, but to do precisely the one thing that will force it to not only cut rates, perhaps to negative, while doing even more QE.
This scenario is also bullish for rates because the Fed would, at the very least, stop rolling down its SOMA portfolio. More likely it would restart asset purchases in an attempt to stimulate the economy once more, pushing yields further down. We have argued in the past that unconventional forms of monetary accommodation are here to stay. The minutes of the October meeting confirm this view, noting that some policymakers felt it would be “prudent to have additional policy tools” because a lower long-run equilibrium real ratemakes it more likely that reductions in the Funds rate alone would not be sufficient to stimulate the economy in the event of a downturn in the future.
Whether this error will crush what little credibility the Fed has and be its final error, eitherpolicy or communication, will be revealed in the very near future.
Good luck Janet.
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