We’re continuing our new experiment this week running a weekly post each Monday to expand upon the quotes that we gather in our weekly digest. The weekly digest is intended to be an unbiased view of what we are hearing from management teams, and our Monday piece will try to interpret those views and hopefully help steer readers towards insights that can have a real impact on investment decisions. This is a pilot project, so please give your feedback! Click here to receive both posts weekly via email.
This week we’ll focus on takeaways from last week’s Fed meeting. By now there has been plenty written about the Fed, and we know that many readers suffer from Fed fatigue, but the Fed matters. Its actions are fundamental to the pricing of securities markets and changes in its policies have dictated economic cycles for nearly 100 years. Here were a few insights from last week’s press conference:
1) The Fed is waiting for the whites of inflation’s eyes
Yellen’s new explanation for delaying the increase is that “the economy has a little more room to run than might have been previously thought.” While this is an ambiguous statement, we (and the market) have taken this to mean that the Federal Reserve does not expect to meaningfully raise interest rates until inflation returns above its 2% target rate.
Even though Janet Yellen explicitly said that “I’m not in favor of the whites of their eyes sort of approach,” it looks more and more like this is exactly what the Fed is looking for. The Fed appears to have delayed raising rates based on a single day 2% decline in the stock market in mid-September. When the board is that jittery, it suggests that the Fed will not raise rates meaningfully until it believes that it has a good reason to.
2) Watch for changing perceptions of the neutral rate
The Fed now appears to be focusing in on a concept of the “neutral rate” for interest rates. Yellen described this as “the interest rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel.”
It looks like the Fed believes that the current neutral rate is very low. Since the beginning of this year, Yellen seems to be buying into the idea that we are in a “new normal” economy. She explicitly used this terminology in her press conference: “we’re struggling with difficult set of issues about what is the new normal in this economy,” and also voiced concern about longer term economic growth: “we have further written down our estimate of the longer run normal growth rate. And with that reflects is in assessment that productivity growth is likely to remain low for an extended time.”
The neutral rate is not something that is set in stone though. It is something that is highly theoretical, subjective and something that cannot be calculated. For this reason the neutral rate is subject to the same revisions that any other Fed indicator is, if not more.
3) The Fed is under increasing political pressure
Although the Federal Reserve likes to champion its independence, in reality the Fed does not operate in a political vacuum and historically has yielded to the demands of the President and Congress, because it knows that is only independent as long as the government allows it to be.
Ahead of this year’s presidential election, the Fed is under increased political scrutiny. This could go away after the election, or it could potentially get worse if an adversarial President is elected. Either way, Yellen was asked multiple times about political motives and gave an impassioned response to one question:
“I have no concern that the Fed is politically motivated, and I will assure that you will not find any signs of political motivation when the transcripts are released in five years. We– I–It is important that we maintain the confidence of the public, and I do believe that we deserve it.”
Even if the Fed is not explicitly acting with political motivations, it cannot escape politics though. Its actions create economic winners and losers and as a result it will always be tied to the goals of elected officials. There is no such thing as an interest rate that is best for all citizens. While a low interest rate may promote near term economic growth and inflation, economic growth and inflation at all costs are not necessarily good for all Americans. Property owners benefit at the expense of lenders and wage earners in an environment in which GDP growth is allowed to exceed wage growth and interest rates. The best that policymakers can do is engineer a fair interest rate that properly balances the interests of varied stakeholders in the economy. When one set of stakeholders benefits more than another there will tend to be a political response, which is what we may be seeing in this election.
4) Beware of Commercial Real Estate
Yellen did pay lip-service to the idea that low interest rates could lead to asset bubbles in her press conference, but felt that in general asset valuations are not out of line with historical norms.
“interest rates both here and in advanced countries around the globe appeared to be very low. And that is an environment that, if we do have to live with that for a long time, we have to be aware that it does give rise to a reach for yield as individuals and investors seek to, perhaps, take on risk or lengthen maturities to seek higher yields…Overall, I would say that the threats to financial stability I would characterize, at this point, as moderate…In general, I would not say that asset valuations are out of line with historical norms”
While we’re not sure how Yellen justifies the assertion that “asset valuations are not out of line with historical norms” it was interesting that she did specifically mention Commercial Real Estate as one area of concern.
“there are areas my colleague President Rosengren is focused on commercial real estate where price to rent ratios are very higher, or cap rates are very low. And that’s something that has caught our attention…We’ve recently issued new supervisory guidance pertaining to commercial real estate. I would say in the area of commercial real estate while valuations are high, we are seeing some tightening of lending standards and less debt growth associated with that rise in commercial real estate prices.”
Especially at this point in the business cycle, we would strongly caution investors in Commercial Real Estate to take this information into account. If the Federal Reserve chooses to target Commercial Real Estate as a sector that is overheated, it is inevitable that the sector will ultimately be slowed by the pressure of the Central Bank. It is completely within the Fed’s power to slow the Commercial Real Estate market.