Global markets took comfort from Federal Reserve Chair Janet Yellen’s Congressional testimony, the main policy message of which was we’re not far from where it wants to be in terms of its interest rate targets.
That would be a “neutral” federal funds rate, one that neither stimulates nor retards the economy. That would be about 0% in real terms, that is, after inflation, according to Fed officials, which, as Yellen, noted is not far from the central bank’s current target range of 1%-1.25%.
The implication was the “long-anticipated rise in interest rates is likely to be far smaller than the conventional wisdom embodies in the forecasts of the great majority of economists.” Since then, the Federal Open Market Committee raised its fed funds target four times in 25-basis-point (one-quarter-percentage point) increments—less than what had been forecast by the Fed for the end of 2016. And at 2.34%, the 10-year Treasury note yield is almost exactly where it was in November 2015, contrary to near-universal predictions the bond market benchmark would be well north of 3%.
A daily earlier, Fed Gov. Lael Brainard confirmed in a speech at a conference at the New York Fed the neutral fed funds rate was about 0% in real terms. That drew on research at the San Francisco by Thomas Laubach, an economist at the Fed Board of Governors, and the bank’s president, John C. Williams, which was cited in the November 2015 column. The Laubach-Williams research found the neutral rate plunged into negative territory after the financial crisis but is estimated at around 0% for the longer-term.
The Fed’s preferred inflation measure, the “core” personal consumption deflator, is running at a 1.4% year-over-year rate, well below Yellen & Co.’s 2% target. She continued to blame “transitory” factors for the persistent inflation undershoot, including the recent price cuts embedded in the mobile phone carriers’ unlimited data plans.
The PCE deflator may significantly understate the true level of inflation faced by consumers. As the ever-sharp-eyed Peter Boockvar, chief market analyst of the Lindsey Group, notes there are more important things than cell phone plans holding down the inflation readings.
The PCE measures health-care costs differently from the more familiar consumer price index. The PCE measures both consumers’ out-of-pocket costs and medical-care providers’ costs; the latter have been held down by cuts in Medicaid and Medicare reimbursement rates. The CPI only measures out-of-pocket costs. In the core PCE, the health-care costs, which are depressed by government price fixing, account for 25% of the index. In the core CPI, health care accounts for 10%. In any case, the core CPI has been running over 2% for 17 months through May. The June CPI, released this morning, held flat. The core CPI edged 0.1% higher.
As these anomalies work themselves out and the core PCE does approach the Fed’s 2% target, that would translate into two, maybe three 25-basis-point hikes. The fed funds futures market, however, sees slightly less than even-money odds of a December hike, just a 49% probability of a target range of 1.25%-1.50% or higher, according to Bloomberg calculation. As for another boost to 1.50%-1.75% or above, Bloomberg puts a probability of just over 40%--not until September 2018.
The low probability of fed funds hikes may reflect the other part of the normalization process of Fed policy, the reduction of the central bank’s $4.5 trillion balance sheet, which Yellen allowed could happen fairly soon. Odds favor the start of the paydown of maturing Treasury and agency mortgage-backed securities to be announced after the Sept. 19-20 FOMC meeting, with more discussion at the July 25-26 confab.
Brainard seemed to suggest the timing of rate hikes would depend on inflation getting up to target while the “quantitative tightening” through shrinking the balance sheet would likely follow if data on the labor market and economic activity remained strong. Yellen also said balance sheet adjustment could start “relatively soon” if the economy remained on track and the timing of rate hikes will depend on inflation.
Michael Feroli, JP Morgan’s keen Fed watcher, observes there is no obvious reason why the balance-sheet adjustment should be keyed to growth and rate hikes should relate to inflation. Yellen’s suggestion the balance sheet reduction could begin “fairly soon” leaves open the chance of it commencing later this month but Feroli writes no big policy move has come at an FOMC meeting with no press conference afterwards, as is the case in July.
How the Fed’s asset reduction will play out will play out is more uncertain than its timing. Feroli’s boss, JP Morgan Chase CEO Jamie Dimon, earlier this week suggested it may not go as smoothly as expected.
As for future rate hikes, they seem less uncertain. The Fed aims to get to a 0% real rate, maybe by 2018. You read it here in 2015.