Fed Governor Lael Brainard at the NBER ’s Monetary Economics Summer Institute

Normalization underway

“In the United States, in my assessment, normalization of the federal funds rate is now well under way, and the Federal Reserve is advancing plans to allow the balance sheet to run off at a gradual and predictable pace. And for the first time in many years, the global economy is experiencing synchronous growth, and authorities in the euro area and the United Kingdom are beginning to discuss the time when the need for monetary accommodation will diminish.”

 

The FOMC delayed balance sheet normalization for a reason

“the Federal Open Market Committee (FOMC) decided to delay balance sheet normalization until the federal funds rate had reached a high enough level to enable it to be cut materially if economic conditions deteriorate, thus guarding against the risk of returning to the effective lower bound (ELB) in an environment with a historically low neutral interest rate. The greater familiarity and past experience with the federal funds rate also weighed in favor of this instrument initially. Separately, for those central banks that, unlike the Federal Reserve, moved to negative interest rates, there may be special considerations associated with raising policy rates back into positive territory.”

He expects balance sheet normalization to start soon 

“If the data continue to confirm a strong labor market and firming economic activity, I believe it would be appropriate relatively soon to commence the gradual and predictable process of allowing the balance sheet to run off.”

He thinks the neutral real fed funds rates will remain close to zero

“In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance… in recent days, we have begun to hear acknowledgement from other major central banks that they too are seeing conditions that suggest policy normalization could be on the table before too long, against the backdrop of a brighter global outlook…the pace and timing of how central banks around the world proceed with normalization, and the importance of balance sheet policy relative to changes in short term rates in these normalization plans, could have important implications for exchange rates and financial conditions globally.”

 

https://www.federalreserve.gov/newsevents/speech/brainard20170713a.htm

FOMC statement on monetary Policy 14th June 2017

Generally:

“…the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have moderated but have been solid..the unemployment rate has declined. Household spending has picked up in recent months, and business fixed investment has continued to expand.”

On inflation

“On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”

Rates forecasted to remain low

“The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

Balance sheet normalization to start this year

“The Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated. This program…would gradually reduce the Federal Reserve’s securities holdings by decreasing reinvestment of principal payments from those securities”

Federal Reserve FOMC statement 3.3.2017

Slowed economic activity this quarter

“Information received since the Federal Open Market Committee met in March indicates that the labor market has continued to strengthen even as growth in economic activity slowed. Job gains were solid, on average, in recent months, and the unemployment rate declined. Household spending rose only modestly, but the fundamentals underpinning the continued growth of consumption remained solid. Business fixed investment firmed. Inflation measured on a 12-month basis recently has been running close to the Committee’s 2 percent longer-run objective.”

…one they view as transitory

“The Committee views the slowing in growth during the first quarter as likely to be transitory and continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term. Near-term risks to the economic outlook appear roughly balanced.”

The status quo remains for now

“In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 3/4 to 1 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.”

Chair Janet L. Yellen Before the Joint Economic Committee 17th November

Relatively steady unemployment rate

“Job gains averaged 180,000 per month from January through October, a somewhat slower pace than last year but still well above estimates of the pace necessary to absorb new entrants to the labor force. The unemployment rate, which stood at 4.9 percent in October, has held relatively steady since the beginning of the year. The stability of the unemployment rate, combined with above-trend job growth, suggests that the U.S. economy has had a bit more “room to run” than anticipated earlier.”

Growth is picking up in the US

“…U.S. economic growth appears to have picked up from its subdued pace earlier this year. After rising at an annual rate of just 1 percent in the first half of this year, inflation-adjusted gross domestic product is estimated to have increased nearly 3 percent in the third quarter.”

On Inflation

“Turning to inflation, overall consumer prices, as measured by the price index for personal consumption expenditures, increased 1-1/4 percent over the 12 months ending in September, a somewhat higher pace than earlier this year but still below the FOMC’s 2 percent objective. Much of this shortfall continues to reflect earlier declines in energy prices and in prices of non-energy imports. Core inflation, which excludes the more volatile energy and food prices and tends to be a better indicator of future overall inflation, has been running closer to 1-3/4 percent.”

Looking ahead:

“…I expect economic growth to continue at a moderate pace sufficient to generate some further strengthening in labor market conditions and a return of inflation to the Committee’s 2 percent objective over the next couple of years. This judgment reflects my view that monetary policy remains moderately accommodative and that ongoing job gains, along with low oil prices, should continue to support household purchasing power and therefore consumer spending. In addition, global economic growth should firm, supported by accommodative monetary policies abroad. As the labor market strengthens further and the transitory influences holding down inflation fade, I expect inflation to rise to 2 percent.”

Gradual increases in fed rates expected

“The FOMC continues to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain maximum employment and price stability. This assessment is based on the view that the neutral federal funds rate–meaning the rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel–appears to be currently quite low by historical standards…gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.”

On speculations that she may resign

“it is fully my intention to serve out my term.”

Fed Chair Janet L. Yellen at Jackson Hole, Wyoming

https://www.federalreserve.gov/newsevents/speech/yellen20160826a.htm

Current economic situation in the US

“U.S. economic activity continues to expand, led by solid growth in household spending. But business investment remains soft and subdued foreign demand and the appreciation of the dollar since mid-2014 continue to restrain exports. While economic growth has not been rapid, it has been sufficient to generate further improvement in the labor market…Although the unemployment rate has remained fairly steady this year, near 5 percent, broader measures of labor utilization have improved. Inflation has continued to run below the FOMC’s objective of 2 percent, reflecting in part the transitory effects of earlier declines in energy and import prices.”

Expect the federal funds rate to increase

“Looking ahead, the FOMC expects moderate growth in real gross domestic product (GDP), additional strengthening in the labor market, and inflation rising to 2 percent over the next few years. Based on this economic outlook, the FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives…”

…Unless data to the contrary comes in.

“Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee’s outlook.”

The expanded toolkit has been helpful

“In light of the slowness of the economic recovery, some have questioned the effectiveness of asset purchases and extended forward rate guidance…Studies have found that our asset purchases and extended forward rate guidance put appreciable downward pressure on long-term interest rates and, as a result, helped spur growth in demand for goods and services, lower the unemployment rate, and prevent inflation from falling further below our 2 percent objective.”

Interest on reserves seems to be here to stay

“…at some point after the process of raising the federal funds rate is well under way, we will cease or phase out reinvesting repayments of principal from our securities holdings. Once we stop reinvestment, it should take several years for our asset holdings–and the bank reserves used to finance them–to passively decline to a more normal level. But even after the volume of reserves falls substantially, IOER (Interest on Excess Reserves) will still be important as a contingency tool, because we may need to purchase assets during future recessions to supplement conventional interest rate reductions.”

Real neutral interest rate is close to zero presently

“By some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving. If so, then the average level of the nominal federal funds rate down the road might turn out to be only 2 percent, implying that asset purchases and forward guidance might have to be pushed to extremes to compensate.”

New tools to be considered

“Looking ahead, we will likely need to retain many of the monetary policy tools that were developed to promote recovery from the crisis. In addition, policymakers inside and outside the Fed may wish at some point to consider additional options to secure a strong and resilient economy.”

In sum

“Although fiscal policies and structural reforms can play an important role in strengthening the U.S. economy, my primary message today is that I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.”

Atlanta Fed President Dennis Lockhart Interview with WSJ

http://www.wsj.com/articles/transcript-atlanta-feds-dennis-lockhart-interview-in-jackson-hole-wyo-1472320365

The US economy is doing better

“I think the U.S. economy is expanding at a modest pace. The second quarter (gross domestic product) number—which was 1.1 (percent annual rate of growth), just revised slightly yesterday—I think overstates the slowdown or a slowdown. We have been looking through that number to an account in the GDP accounts called real final sales, which is GDP less inventory and what we see there is a better picture and a more consistent picture over the last few quarters. So I think the economy is chugging along, and I’m not one who is interpreting the headline GDP number as somehow suggesting that we have slowed from what was already a slow expansion.”

A more settled global risk environment

“…when you go all the way back to the beginning of the year, you had a lot of things related to China—the Chinese equity markets, the Chinese slowdown spilling over to emerging markets—and then later there was the buildup to Brexit. I think we’re past those things, and the overall global risk environment is a bit more settled in my opinion. So I think really, for me, the focus is on the domestic economy.”

On raising interest rates

“I’m ready to talk about it… knowing what I know today, if the economy in the next few weeks performs consistent with my sense of the economy, then I think we ought to have a serious discussion at the September meeting. So I, in no way, rule out September and look to December or look to even the November meeting. ”

They are watching from a distance the phenomenon that is negative interest rates

“I don’t want to encourage the view that the (Federal Open Market Committee) or the Fed is in any serious way considering negative interest rates for this economy. I view it as an interesting experiment that’s going on elsewhere—fortunately, I think. We’ll see what the consequences of negative interest rates and the results that they produce…there could be institutional damage over time with negative interest rates, and it bears watching in Europe and Japan. ”

On the long term impact on negative interest rates

“One is real damage to the financial system through banks and other intermediaries like life insurance companies or insurance companies in general that depend upon fixed-income investments or lending that is priced off of short-term interest rates. Even in our low-rate environment in the United States, we are seeing some of those institutions really express a lot of stress…When you go to negative interest rates, you can—in theory, at least, you can really do some damage to some important industries…Do I see any direct evidence of that yet? I think it’s probably too early.”

Fed Vice Chairman Stanley Fischer Speech at The Aspen Institute

http://www.federalreserve.gov/newsevents/speech/fischer20160821a.htm

They are close to their targets on inflation and full employment

“The Fed’s dual mandate aims for maximum sustainable employment and an inflation rate of 2 percent, as measured by the price index for personal consumption expenditures (PCE). Employment has increased impressively over the past six years since its low point in early 2010, and the unemployment rate has hovered near 5 percent since August of last year, close to most estimates of the full-employment rate of unemployment. The economy has done less well in reaching the 2 percent inflation rate. Although total PCE inflation was less than 1 percent over the 12 months ending in June, core PCE inflation, at 1.6 percent, is within hailing distance of 2 percent–and the core consumer price index inflation rate is currently above 2 percent. So we are close to our targets.”

Resilient employment figures

“…the behavior of employment has been remarkably resilient…Employment has continued to increase, and the unemployment rate is currently close to most estimates of the natural rate.”

…but slow labour productivity growth

“Turning briefly to recent developments, the pattern of high employment growth and low productivity growth that we have seen in recent years has continued this year..The combination of strong job gains and mediocre GDP growth has resulted in exceptionally slow labor productivity growth.”

We have good news and bad news

“Are we doomed to slow productivity growth for the foreseeable future? We don’t know.On the encouraging side, the technological frontier appears to be advancing rapidly in some sectors, and there are hints that the firm start-up rate is improving. On the more discouraging side, investment continues to disappoint–and so the current capital stock is smaller and embodies fewer frontier technologies than might otherwise be the case–and the productivity slowdown is a global phenomenon, suggesting that it may not be easily or quickly remedied.”

Look beyond monetary policy to boost productivity growth

“…monetary policy is not well equipped to address long-term issues like the slowdown in productivity growth. Rather, the key to boosting productivity growth, and the long-run potential of the economy, is more likely to be found in effective fiscal and regulatory policies.”

QE Effect on S&P 500

After QE3’s announcement in mid September there was some concern that the effect of QE on the market had eroded because the S&P 500 proceeded to sell off by 5%.  It could be true that QE is losing its efficacy, but it’s worth noting that true balance sheet expansion didn’t really start until mid November because of the mechanics of MBS purchases.  It therefore may or may not be coincidental that MBS started to show up on the Fed’s balance sheet around the same time that the S&P 500 found a bottom.

Below is a chart of how the S&P 500 has done during periods of QE, but instead of using the announcement dates, the chart highlights the times that the Fed’s holdings of Treasuries and MBS were increasing (note that this analysis therefore excludes operation twist).  Since the S&P 500 is now hitting new cycle highs, perhaps one could argue that QE hasn’t exactly lost its potency.

How Long Can Real Interest Rates Remain Negative?

Ray Dalio made some news this week when he acknowledged that interest rates had probably gone about as low as they could possibly go and that the next big opportunity will be shorting the bond market.  I’m inclined to agree, but there is some historical precedent for rates to go lower and stay there for even longer.

Dalio argued that real rates are currently negative (nominal rate minus inflation)–which they are–but they were also negative for 10 years between 1936 and 1946 as shown by the chart below, which compares Moody’s average Aaa bond yield to the realized 10 year forward inflation rate.  Inflation was high during this period, reaching above 10% in some years thanks to WWII.  The fact that rates stayed low is a testament to the fact that it’s not a good decision to try to fight the Fed.

Real Interest Rates Negative World War II
Used Aaa bonds as proxy for risk free rate.  Source: Federal Reserve Data

Annual Change in Monetary Base Since 1918

After yesterday’s post forecasting that we could see a 40% y/y increase in the monetary base in 2013, I thought it might be good to look at a long term chart of the monetary base to put that number into context.  Below is a chart showing the rolling y/y increase in the monetary base since 1918.  The only other time there has been such a steep increase in the US base was during the depression/WWII era during which there were three different periods of 20% annual growth in the base.