A postmortem of the Fed’s failed attempt to normalize
The June 19 Federal Reserve Open Market Committee (FOMC) meeting, which greased the skids for interest rate cuts, marked the end of Fed efforts to normalize rates. For the last three years, the Fed has believed an appropriate normalized level for its fed funds policy rate would be between 2.50-3.00 percent.
In March, the Fed backed off reaching that level and now has thrown in the towel on reaching its own goal. Why?
Much has been made of potential negative trade impact on Fed policy, but the Fed’s own projections show increased expectations for growth with lower unemployment.
A major factor pushing the Fed to lower rates has been the message from financial markets, which moved rates lower before the Fed’s March halt and even more aggressively before the June meeting.
The yield on the 2-Year Treasury, an important indicator of expectations of Fed policy, fell from a peak of 2.89 percent in November 2018 to 1.86 percent before the FOMC June meeting.
Methodology for calculating future expectations in current bond yields suggests markets now expect future short-term rates to fall below 1.50 percent. The financial markets have been more accurate than the Fed at projecting future interest rate movements.
The problem for the Fed is that the financial markets are still affected by huge liquidity remaining from the central bank’s quantitative easing (QE) program. The Fed can’t get out of the way of its own balance sheet.
Historically, the size of the Fed’s balance sheet has affected interest rates; a bigger balance sheet pushes rates below what they would otherwise be and vice versa. For 30 years before the financial crisis, the Fed’s balance sheet averaged 6 percent of U.S. gross domestic product. This grew to 26 percent of GDP following QE when U.S. government interest rates were effectively zero.
When the Fed finishes shrinking its balance sheet in September, it is projected to be 17 percent of GDP, about halfway to the normal pre-crisis level. While the Fed believes a normal level for fed funds is 2.50-3.00 percent, the still-swollen balance sheet has been pushing rate expectations to about half that level.
The Fed won’t have normal rates until it has a normal balance sheet.
The other factor in addition to financial market pressure that is pushing the Fed to lower rates is its shortfall attaining the 2-percent inflation target. After touching 2 percent early in 2018, the Fed’s preferred measure of inflation, core Personal Consumption Expenditure prices excluding food and energy, has fallen to 1.6 percent.
The Dallas Fed has produced a “Trimmed Mean” indicator that suggests inflation will revert to 2 percent, but this indicator has been negatively correlated with future inflation since the financial crisis and is not reliable.
The Fed’s desire to boost inflation to 2 percent from its 20-year average of 1.7 percent is questionable with the economy performing so well. The prestigious Bank for International Settlements, central bank for central bankers, has found for OECD countries, “… there is a significant negative correlation between inflation and income growth during rather long periods.”
The Fed’s attachment to its 2-percent goal is particularly questionable with the failure of other major central banks to reach this target. Japan and Europe have had quantitative easing programs even larger than the Fed’s along with negative interest rates and are nowhere close to 2 percent.
If, after QE of 20 percent of GDP, years of zero interest rates, full employment or better, and above-trend growth, inflation still is short of 2 percent, what exactly will get it there?
Of course, as with any institution, the Fed attaches great importance to its perceived credibility, and, having set the 2-percent goal, it wishes to attain it.
The Fed also deems its credibility important to the financial markets and the determination of inflation, but, currently, the financial markets’ yields on U.S. Treasury Inflation Protected Securities are projecting inflation at the equivalent, using the Fed’s core PCE measure, of 1.5 percent for the next 30 years! Where is the effect of the Fed’s credibility?
The other reason for the Fed’s objective of attaining 2-percent inflation is, as discussed earlier, the central bank wishes to provide margin for future stimulative rate cuts in the event of a recession. This can seem an effort to insure in case of future mistakes, but wouldn’t it be better to shrink the balance sheet to boost rates rather make a vain effort to boost inflation?
The financial markets’ message is clear — Fed normalization has failed.