Throughout the long period of the Federal Reserve’s “lower and longer” period of highly accommodative rates and forward guidance in the run up to the rates lift-off in December 2015, Federal Reserve Chair Janet Yellen was among the most skeptical of Fed officials about using higher rates to “get into the cracks” to dampen market excesses that might threaten financial stability.
We think, however, that Chair Yellen will modestly modify those views in her speech on “Financial Stability” in Jackson Hole this Friday, a new messaging meant to lend hawkish support to a continued gradual pace in rates normalization despite the current persistence in low inflation.
*** It is telling for a conference on “Fostering a Dynamic Global Economy” that Chair Yellen should opt to speak on financial stability rather than, say, delving deeper into R* or why low inflation is proving so persistent. Indeed, with the Fed engulfed in a fierce debate over inflation dynamics, with a core of doves wary of further rate hikes without firmer evidence of higher inflation, we suspect Yellen is likely to move the policy debate beyond the immediate low inflation question to the rates trade-off further down the road in financial instability as an elevated risk to the global recovery. ***
*** To be sure, Yellen has been skeptical that a tool as blunt as rates could be used to promote financial stability — preferring instead to mostly rely on macro-prudential policy — but she has never ruled out that higher rates “may, at times, be needed to curb risks to financial stability.” We think Yellen will caution that one of those times may be looming, and that continued rate increases would now be prudent as a critical check on the risks to financial stability the FOMC no longer sees as merely “notable” but already “elevated” — especially when Congress may potentially go too far in unwinding Dodd-Frank. ***
*** Along these lines, we still expect the Fed to continue its twin track policy normalization: in September, the FOMC is all but certain to start its balance sheet normalization (we don’t think the political dysfunction on Capitol Hill over an increase in the debt ceiling will delay its announcement, though it could delay which auction sees the first asset run-off) and; in December, with financial stability becoming increasingly aligned with the employment mandate, the FOMC is more likely than not to hike rates a third time this year (SGH 6/14/17, “Fed: Still Betting on Mr. Phillips). ***
In other words, the market may be seriously underpricing the determination of the Yellen-led FOMC to press ahead on rates normalization despite the current persistence in low inflation. Indeed, the low inflation debate is explicitly linked to and perhaps pushing the financial stability question to the forefront of the broader policy debate inside the Fed.
An Unsettling “Co-existence”
After the Fed opened the year with a more assertive rate messaging in the run up to the March rate hike (SGH 2/22/17, “Fed: Hello March”), its rates policy messaging since the March and June hikes has become distinctly more uncertain with the drop in inflation bringing out a vocal minority of four to six FOMC members who are now solidly “show me” skeptics of further rate increases until there is firmer evidence of a renewed pick up in inflation.
Indeed, the most noteworthy takeaway from the FOMC July meeting Minutes last week was the extensive policy debate over the renewed persistence in low inflation and the unsettling “co-existence of low inflation and low unemployment” that dominated the meeting. If we did not know better, we would begin to think the persistence in low inflation has put the Fed on its back foot, a little unsure over what exactly drives inflation and more than a bit unsettled over whether their work-horse, slack-based forecasting models and the assumptions written into them accurately reflect the post-crisis economy and price forming realities.
“Maybe there is something else going on,” Yellen conceded in her Capitol Hill testimony last month.
At the heart of the Fed’s existential debate is a crisis of faith over the Phillips Curve assumptions, that inflation is largely a labor cost dynamic, and that ongoing tight labor market pressures will eventually overwhelm the multiple “idiosyncratic” factors currently holding inflation down, rolling them out of the data “on a 12 month basis.”
The Phillips Curve has admittedly never really worked except in a rearview mirror, and for a solid mainstream majority within what is an admittedly very conservative institution, it retains its usefulness as a conceptual framework, for just as sure as the sun will emerge from every solar eclipse, so too will an undershoot of the Fed’s employment mandate below its estimated longer run levels in time translate into a broad-based upward pressure on margins and prices that will be hard to reverse without a sharp shock to demand.
Those broadly-based upward price pressures will be further boosted by the effects of the dollar weakening this year, a modest uptick in fiscal stimulus, range-bound to slightly higher oil prices, and an assumed continued global recovery.
So on balance then, prudence would argue for another rate increase before too much longer to maintain the gentle ascent in rates normalization towards an assumed effective neutral rate of around 1.75%-2% by this time next year.
But with three rate hikes since December under their belt and a recent string of inflation prints turning unmistakably lower, the FOMC’s July meeting saw a remarkable rates policy debate, with a broad-based questioning of the most fundamental assumptions of the dominant orthodoxy.
“Several” FOMC participants, for instance, argued the risks to the inflation outlook were in fact “tilting to the downside” with a “few” participants even citing “evidence suggesting that this framework was not particularly useful in forecasting inflation.” A competing narrative was offered to explain the painful co-existence of low inflation and low unemployment, that among other factors global distribution methods and still fierce technologically-driven downward price pressures were eroding pricing power and brand loyalty regardless of what are in fact fairly subdued upward wage pressures.
What’s more, the arguments by the majority that “overshooting” full employment with a too low unemployment rate could put the desired “soft landing” of the economy at risk — that the Fed would be forced to raise rates so aggressively to head off a building inflation momentum that it derails the recovery — contains a flawed middle premise in its logic, that there is unlikely to ever be a need to raise rates rapidly to head off an “accelerationist” inflation; there will be plenty of time to resume a gradual pace of rate tightenings once inflation is back on an upward path.
The Minutes were quick to note “most participants thought that the framework remained valid” and several FOMC members, including New York Fed President Bill Dudley, have in the days since done their best to make the base case that the rate policy normalization strategy remains firmly intact and that a December rate hike is still more likely than not.
Nevertheless, an awkward problem remains in that even the most fervently hawkish leaning Committee members do not really expect much in the way of rising inflation to show up in the data any time soon that would help to bolster the case for a rate hike; “most” Committee participants believe that inflation will pick up over the “next couple of years” to eventually “stabilize around” the 2% inflation target, that is to say, not by December.
So in effect, something else may be needed to bolster the faith in the policy orthodoxy. And like Kant refuting Hume’s skepticism by turning faith on its head, Yellen we suspect is likely to do something of just that on Friday, by nudging the Fed’s rates debate towards the financial stability question.
From “Notable” to “Elevated”
As the low inflation debate got underway a month or so ago, we have been expecting more of a concerted effort in the Fed policy messaging to turn to financial stability risks (see SGH7/5/17, “Fed: Return of the Inflation Question”) that would in fact be mirroring the Fed’s building concerns over what an extended period of low rates could portend for financial market risk-taking in search of yield.
Kansas City Fed President Esther George and Boston’s Eric Rosengren have both been early in warning of the risks to the economy in excessive risk taking and valuations, or in inflated real estate lending. Yellen herself noted “asset valuations are somewhat rich by some metrics” in her July Humphrey Hawkins testimony, and Vice Chair Stan Fischer gave a speech in late June just on the issue of financial stability.
Fed officials however tend to dance gingerly around the valuations and asset bubble question, for good reason, and they invariably tend to conclude as they did in July that “appreciable risks to financial stability” were lacking — for now — primarily on the grounds of a reassuring absence of excessive leverage and what are well capitalized banks.
Fischer, however, noted in his remarks that the causality can run in both directions and quickly transform into an accelerating growth in credit and leverage as investors become increasingly complacent later in the cycle.
And while that same competing narratives that split the debate over the nature of inflation dynamics also tended to frame the debate over asset valuations at the FOMC July meeting — maybe current valuations simply reflect the new reality of low rates? — it was singularly noteworthy that in drafting the July FOMC Minutes, the Fed scribes referred to financial stability risks as rising from the merely “notable” to “elevated.”
It was a clever turn of phrase, and a significant one, for we think Yellen may pick up on that theme to make it a centerpiece of her speech on Friday.
It is true that Yellen has long been skeptical of the arguments that higher rates could and should be used to dampen financial excesses and potential systemic instabilities because unlike macro-prudential policy, they “get into all the cracks,” as so famously put by former Fed governor Jeremy Stein.
When Stein first laid out his arguments in 2013 and 2014, Yellen felt that the immediate costs in lost jobs amid a still fragile recovery was simply too high to raise rates to safeguard against a potential risk of excessive financial market risk taking and inflated valuations down the road. It echoed the sense the Fed invariably faces a Hobson Choice between raising rates too early to dampen an assumed rising real inflation or backing away to hold rates steady for a bit longer but stoking financial market excesses and an asset price inflation.
But even when pushing back against interest rates to counter financial stability risks, Yellen also conceded in an important 2014 speech that “there may be times when an adjustment in monetary policy may be appropriate.”
And more to the point, crucially, not only does the Fed increasingly see financial stability risks as more elevated, those risks are coming to the fore at the same time the labor market is at or near full employment; with a risk seen in overshooting the employment mandate, the calculus over an informal financial stability mandate may be changing in that nudging rates gradually higher to dampen financial excesses and the higher rate path to safeguard against an overshoot of the employment mandate are increasingly aligned in purpose.
To be fair, Yellen is more likely than not to signal only a modest shift from her stance in 2014, that while there is not an explicit immediate threat to financial stability, that may not hold true a year from now, which is where monetary policy is more or less directed with its lags.
But as Yellen laid out in her 2014 speech, it would be “crucial” policy makers communicate their views on risks to financial stability and how they influence appropriate monetary policy stance.” Friday may prove to be one of those moments.