On The Fed Credibility Gap, by Tim Duy: Financial market participants do not believe the Fed will pursue their expected policy path:
David Wessel opines on the reasons from his post at Brookings:
First, financial markets are not interested in the median Fed official; they’re interested in Chairwoman Janet Yellen, and they assume her dot is lower than the median...Second, the markets think Fed officials and staff economists are overly optimistic about the U.S. economy, as they have been in the past...Third, there’s the inflation issue. Many do not believe that the Fed will raise rates until underlying inflation is a lot closer to its 2% target....
I will suggest another framework: Financial markets are pricing in a "secular stagnation" scenario that is at odds with Federal Reserve thinking. It is fairly easy to consider this in terms of the Taylor rule. One implication of the "secular stagnation" hypothesis is a decline in real interest rates. Suppose that the short term equilibrium real rate has fallen to zero. Consider the monetary policy implications from a basic Taylor rule:
The black dots are median Fed funds projections from the SEP; the colored dots are the Taylor rule predictions from the midpoint of SEP projections of core inflation and unemployment. In this scenario, monetary policy is only slightly loose by the end of 2015, near-neutral in 2016, and a little tight at then end of 2017.
But notice that even with the 0% equilibrium rate hypothesis, the Taylor-implied neutral Fed funds rate in 2017 is 2.5-3%, still high relative to the market implied rate of 2% at the end of 2017. So let's change the estimate of NAIRU from 5.6% to 5%. This does not appear to be unreasonable given the lack of wage response to date. Moreover, it is close to pre-recession Fed estimates. The results:
I would say this is fairly close to market expectations, albeit with a slightly lower neutral Fed funds estimate of 1.7-1.8% at the end of 2017. It thus appears reasonable to argue that financial market participants are pricing in a secular stagnation story combined with a pre-recession level of NAIRU.
In contrast, the Fed is not seriously contemplating such a story, at least the secular stagnation part. We know this from Federal Reserve Chair Janet Yellen herself:
I know that’s a mouthful, but it says, in effect, that the Committee believes that the economic conditions that have made recovery difficult, we’re getting beyond them. They are optimistic that those conditions will lift. They see the longer-run normal level of interest rates as around 33/4 percent. So there’s no view in the Committee that there is secular stagnation in the sense that we won’t eventually get back to pretty historically normal levels of interest rates. But they have said, it’ll, you know, the economy has required to get where it is a good deal of monetary policy accommodation; we expect to be able to normalize policy.
The biggest risk to the expansion is a dogmatic view of the neutral Fed funds rate on the part of the Federal Reserve. Markets are pricing in a secular stagnation story. The decline in long yields is also consistent with that story. So at the moment, financial market participants are saying the Fed has less room to maneuver than monetary policymakers believe. The Fed, I fear, is not taking sufficient heed of those signals.
Would it be outrageous to think that the Federal Reserve could find itself backtracking after just 200bp of rate hikes? Not if Sweden serves as any example. The Riksbank attempted to normalize policy when long-term rates were still low, and continued despite minimal gains in those rates. The result? The Riksbank managed to get to 200bp before being forced to reverse course:
I suspect there will be disbelief if not outright hostility to the idea that equilibrium short term real rates are near zero. Monetary policy makers will not like the result because it implies a narrow range to the effectiveness of their interest rate tools. They will also fear the asset bubble implications; many market participants will lament the same. I understand. That those in the rentier business would be hostile to the euthanasia of the rentier is expected and understandable. But if (safe) real returns are indeed collapsing toward zero, then obtaining higher returns will require taking on more risk, and more of those in the rentier business using more money to chase more risk will undoubtedly yield more asset bubbles of one variety or another. Those entrusted with financial stability will counter with a more costly regulatory environment to limit the creation of those bubbles, thereby making the rentier business even more difficult. In short, the future looks challenging for the rentier business.
Bottom Line: The Fed's expected policy path, and any desire for an even more aggressive policy path pushed by some market participants, is at odds with a secular stagnation scenario. But it appears something similar to that scenario is price into bond markets. If the Fed is not open to such a scenario, they risk tightening too aggressively and turning an expansion that should last at least four more years into one with only two left.