2019 is a benchmark year for U.S. monetary policy with the wind down of the Fed’s quantitative easing (QE) officially ending and the Fed announcing in June its new policy framework moving forward.
It’s an excellent opportunity to resolve major contradictions between its current operating assumptions and financial-market realities.
The first major contradiction is between the Fed’s efforts to influence market expectations of interest rates and inflation and those actual expectations.
This Fed believes “guidance” influences long-term market expectations of interest rates and inflation. Americans of a certain age may remember “jawboning” as an attempt by several hapless administrations to check what became the “Great Inflation.” Is “guidance” more effective talking these rates up than jawboning was talking them down?
In fact, the Federal Reserve Bank of New York surveys interest-rate expectations out to 10 years. At every horizon, these expectations correlate significantly more with historical interest rates than with subsequent realized future interest rates.
The Fed’s own guidance tool, the Federal Open Market Committee’s (FOMC’s) longer-run federal funds projections, is negatively correlated with New York Fed interest rate expectations and positively correlated with past interest rates, nearly perfectly so for lagged, 10-year averages.
That the Fed follows, rather than guides markets is apparent in the FOMC’s dramatic half-percentage-point climbdown in its 2019 fed-funds projection just from December 2018 to March 2019.
What’s true in the financial markets for interest rates also applies to inflation. Breakeven rates measure expected inflation as the difference between inflation-adjusted and regular debt yields. Again, correlation is significantly higher for past than for future inflation.
Interestingly, one measure of expectations for which correlation is higher for future than past inflation is the University of Michigan’s Survey of Consumers Inflation Expectations.
Is it possible a representative sample of Americans, 30 percent of whom cannot perform basic mathematical calculations such as percentages, half of whom cannot read an eighth-grade level book and two-thirds of whom cannot do basic financial computations, forecast inflation better than richly compensated bond traders or multi-degreed Fed economists?
Tempting as this thought may be, the consumer survey is highly correlated with the previous year’s inflation, which, for core personal consumption expectation (PCE) prices, is a better predictor of future inflation than the consumer survey.
Resolving the contradiction between Fed reliance on guidance to influence rates and markets’ reliance on history is particularly important in view of another major contradiction between the Fed’s 2-percent inflation target and its inability to attain it.
Since 1995, core PCE prices averaged 1.7 percent annually, despite 20 percent of GDP being devoted to QE monetary stimulus. In 2018, the measure briefly topped 2 percent for the first time since the financial crisis, but this peak came on heels of a 10-percent drop in the dollar’s foreign exchange value.
Once the dollar bottomed early in 2018, second-half core prices returned to the 1.7-percent average. The Fed has never explained why it adopted an explicit 2-percent target, replacing the implicit 1.5-percent target identified by the San Francisco Fed.
Contradiction between the Fed’s 2-percent inflation target and actual experience becomes pressing, even potentially dangerous, because of the Fed’s goal of symmetry around 2 percent, which entails running with inflation above that level for extended periods to offset undershoots.
Since guidance appears ineffective, stimulus is necessary to establish the track record to influence expectations. The only period since 1995 with inflation above 2 percent was the run-up to the financial crisis, an inauspicious precedent to put it mildly.
Stanford economist John Taylor has described how monetary policy was too loose during this period. Some quibble with specifications of his Taylor Rule, but basic monetary measures illustrate excessive looseness during this time.
By 2008, banking-system assets were growing at their fastest rate since double-digit inflation in the early 1980s, increasing by more than 20 percent of GDP in the preceding decade. From peak to bottom, 2002 to 2008, the U.S. dollar foreign-exchange value fell 37 percent.
Such extraordinary, excessive monetary conditions preceded the sole contemporary period of core inflation above 2 percent, and financial crisis wreckage highlights the danger.
The third major Fed contradiction is between its own goals: On the one hand, to carry a large balance sheet and, on the other hand, to normalize interest rates. For over 100 years, markets and the Fed both understood its balance sheet influenced interest rates.
For most of this time, changes in the Fed’s balance sheet, buying and selling securities to add or subtract bank reserves, were primary means to conduct interest-rate policy. QE boosted Fed assets from 6.0 percent to a peak of 25.2 percent of GDP, and it remains near 19 percent today.
The large balance sheet may yet overhang and dampen market yields as suggested by the Fed’s halting rate-raising short of its neutral-rate objective, as well as by the current kinked yield curve with maturities beyond a year reflecting lower future expected short-term yields.
A fourth contradiction is between the maturity structure of the Fed’s portfolio and the maturity structure of U.S. Treasury debt.
When the Fed buys Treasury securities, it creates interest-paying short-term deposit liabilities to banks, thus shifting Treasury’s exposure from long to short rates. By purchasing long-term U.S. debt during QE and creating short-term deposit obligations, the Fed shifted 10 percent of Treasury’s total debt from long-term to short-term.
Fed purchases of long-term Treasuries paying yields higher than short-term rates create a difference often considered a “profit,” but this is fictional as the Treasury is paying the Fed interest that later returns to Treasury.
The same effect is obtained simply by Treasury changing maturity structure for its issues without Fed intermediation. Unless the Fed limits itself to short-term holdings, it will be changing Treasury’s desired maturity exposure.
With the U.S. economy performing strongly, the Fed’s task is simple: Don’t mess it up. Resolving policy framework contradictions with explanations to Congress, financial markets and the American people will help the Fed avoid potential hazards and risks.
Image credit: Paul Brady Photography