Low Inflation, A Mystery Says The FED

In a speech by FED Chair Yellen, at the Group of 30 International Banking Seminar, she discussed the problem of low inflation, and admitted that their understanding of why it remains so low is imperfect and low inflation may persist.  Perhaps the labour market is really softer than reported; perhaps long term trends will remain lower; perhaps technological and sectorial changes may be impacting. Despite this, she expects the FED rate to rise in the months ahead.

The biggest surprise in the U.S. economy this year has been inflation. Earlier this year, the 12-month change in the price index for personal consumption expenditures (PCE) reached 2 percent, and core PCE inflation reached 1.9 percent. These readings seemed consistent with the view that inflation had been held down by both the sizable fall in oil prices and the appreciation of the dollar starting around mid-2014, and that these influences have diminished significantly by this year. Accordingly, inflation seemed well on its way to the FOMC’s 2 percent inflation objective on a sustainable basis.

Inflation readings over the past several months have been surprisingly soft, however, and the 12-month change in core PCE prices has fallen to 1.3 percent. The recent softness seems to have been exaggerated by what look like one-off reductions in some categories of prices, especially a large decline in quality-adjusted prices for wireless telephone services. More generally, it is common to see movements in inflation of a few tenths of a percentage point that are hard to explain, and such “surprises” should not really be surprising. My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year. Most of my colleagues on the FOMC agree. In the latest Summary of Economic Projections, my colleagues and I project inflation to move higher next year and to reach 2 percent by 2019.

To be sure, our understanding of the forces that drive inflation is imperfect, and we recognize that this year’s low inflation could reflect something more persistent than is reflected in our baseline projections. The fact that a number of other advanced economies are also experiencing persistently low inflation understandably adds to the sense among many analysts that something more structural may be going on. Let me mention a few possibilities of more fundamental influences.

First, given that estimates of the natural rate of unemployment are so uncertain, it is possible that there is more slack in U.S. labor markets than is commonly recognized, which may be true for some other advanced economies as well. If so, some further tightening in the labor market might be needed to lift inflation back to 2 percent.

Second, some measures of longer-term inflation expectations have edged lower over the past few years in several major economies, and it remains an open question whether these measures might be reflecting a true decline in expectations that is broad enough to be affecting actual inflation outcomes.

Third, our framework for understanding inflation dynamics could be misspecified in some way. For example, global developments–perhaps technological in nature, such as the tremendous growth of online shopping–could be helping to hold down inflation in a persistent way in many countries. Or there could be sector-specific developments–such as the subdued rise in medical prices in the United States in recent years–that are not typically included in aggregate inflation equations but which have contributed to lower inflation. Such global and sectoral developments could continue to be important restraining influences on inflation. Of course, there are also risks that could unexpectedly boost inflation more rapidly than expected, such as resource utilization having a stronger influence when the economy is running closer to full capacity.

In this economic environment, with ongoing improvements in labor market conditions and softness in inflation that is expected to be temporary, the FOMC has continued its policy of gradual policy normalization. As the Committee announced after our September meeting, we are initiating our balance sheet normalization program this month. That program, which was described in the June Addendum to the Policy Normalization Principles and Plans, will gradually scale back our reinvestments of proceeds from maturing Treasury securities and principal payments from agency securities. As a result, our balance sheet will decline gradually and predictably.2 By limiting the volume of securities that private investors will have to absorb as we reduce our holdings, the caps should guard against outsized moves in interest rates and other potential market strains.

Changing the target range for the federal funds rate is our primary means of adjusting the stance of monetary policy. Our balance sheet is not intended to be an active tool for monetary policy in normal times. We therefore do not plan on making adjustments to our balance sheet normalization program. But, of course, as we stated in June, the Committee would be prepared to resume reinvestments if a material deterioration in the economic outlook were to warrant a sizable reduction in the federal funds rate.

Also at our September meeting, the Committee decided to maintain its target for the federal funds rate. We continue to expect that the ongoing strength of the economy will warrant gradual increases in that rate to sustain a healthy labor market and stabilize inflation around our 2 percent longer-run objective. That expectation is based on our view that the federal funds rate remains somewhat below its neutral level–that is, the level that is neither expansionary nor contractionary and keeps the economy operating on an even keel. The neutral rate currently appears to be quite low by historical standards, implying that the federal funds rate would not have to rise much further to get to a neutral policy stance. But we expect the neutral level of the federal funds rate to rise somewhat over time, and, as a result, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion. Indeed, FOMC participants have built such a gradual path of rate hikes into their projections for the next couple of years.

How Might Increases in the Fed Funds Rate Impact Other Interest Rates?

From The St. Louis Fed Blog.

The Federal Reserve’s main instrument for achieving stable prices and maximum employment is the target for the federal funds rate. The idea is that by affecting the rate at which banks lend to each other overnight, other interest rates may be affected. In turn, this would also affect nominal variables (such as inflation) and real variables (such as output and employment).

In December 2015, the Fed ended seven years of near-zero policy rates. Through a series of increases since then, the target rate has been gradually raised by one percentage point. The current monetary policy outlook, as stated recently by Fed Chair Janet Yellen, is to continue increasing the target rate due to worries that a strong labor market may create inflationary pressures.1

Questions about Rate Increase Impacts

The fed funds rate is thus expected to continue rising in the near future. This would undoubtedly mean that other short-term interest rates will increase in tandem.

But what about long-term interest rates? What would the impact be on those rates that arguably matter the most for real economic activity, such as mortgages rates, Treasury bond yields and corporate bond yields?

The future is always hard to predict, but we can take an educated guess by looking at the recent behavior of short-term and long-term interest rates, and how they move with the fed funds rate.

Impact on Treasury Yields

The figure below displays three key interest rates over a period of 30 years:

  • The federal funds rate
  • The interest rate on a one-year Treasury bond
  • The interest rate on a 10-year Treasury bond

As we can see, the fed funds rate and the one-year Treasury rate track each other very closely. Although it is still debatable whether the Fed leads or follows the market, movements in the policy rate are associated with similar movements in short-term interest rates.2

In contrast, the interest rate on a 10-year Treasury bond does not appear to move as closely with the fed funds rate. While there appears to be some co-movement, the 10-year interest rate appears to follow its own declining path.3

Impact on Mortgage Rates

Is the interest rate on a 10-year Treasury bond representative of long-term interest rates? The next figure compares this rate to the average rate on a 30-year mortgage.

Clearly, the two move very closely together, though there is a difference in level due to the higher risk, lower liquidity and longer term of mortgages. If we were instead to look at other long-term interest rates, such as the average rate on corporate bonds, the results would be similar.

Impact on the Yield Curve

Given that movements in the fed funds rate are closely linked to movements in short-term interest rates, but less so to movements in long-term interest rates, changes in the policy rate are likely to impact the yield curve.4 The next figure compares the fed funds rate with the difference between 10-year and one-year Treasury bond rates.

This difference is meant to represent the yield curve at each moment in time with a single number. Note that there is a strong negative correlation between the fed funds rate and the term premium of Treasury bonds. When the policy rate increases, the spread between one- and 10-year Treasury bonds decreases.

Although it is still too early to tell, this pattern appears to be present in the latest period of interest rate hikes.

Overall Impact of Fed Funds Rate Target Increases

If the past is any evidence, the projected increase in the fed funds rate will successfully raise short-term interest rates but have a limited impact on long-term interest rates. This will imply a reduction in the term premium for bonds and loans.

These observations rely on the Fed not letting inflation stray significantly away from its annual target, which has been set at 2 percent. It is thus likely that, despite the continuing rate hikes, the government, firms and households will all continue to enjoy historically low interest rates on their long-term liabilities.

There is, of course, the possibility that some unforeseen and fundamental change in the economy will drive long-term interest rates up, but this increase would unlikely be driven by monetary policy alone.

Notes and References

1 For example, see Appelbaum, Binyamin. “Janet Yellen Says Fed Plans to Keep Raising Rates,” New York Times, Sept. 26, 2017.

2 The interest rate on a three-month Treasury bond would look even more similar to the fed funds rate.

3 For further analysis on these trends, see Martin, Fernando M. “A Perspective on Nominal Interest Rates,” Economic Synopses, No. 25, 2016.

4 The yield curve plots interest rates as a function of maturity dates.

Fed Holds Stance on Rate Hikes

In the September 2017 statement the FED remains bullish on the US economy, and says it will start to normalise its balance sheet in October (reversing QE).

Bond yields rose, putting upward pressure on capital market funding. In fact there has been a significant change in trajectory since mid September, with yields rising again.

The immediate impact on US mortgage rates was to lift them, and the expectation is more down the track.

All this points to more upward pressure on Australian mortgage rates, thanks to a combination of higher bank funding costs, and the sense the RBA may lift sooner than was expected even a few days ago.

This will all play out over the next few months, but the sense we get from the market is a stronger view of higher rates sooner.

Here is the Fed’s statement:

Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have remained solid in recent months, and the unemployment rate has stayed low. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans

 

Federal Reserve Board Proposes to Produce Three New Reference Rates

Given questions about the transparency of the U.S. dollar LIBOR rate benchmark, and the quest for a more robust alternative, the US Federal Reserve Board has requested public comment on a proposal for the Federal Reserve Bank of New York, in cooperation with the Office of Financial Research, to produce three new reference rates based on overnight repurchase agreement (repo) transactions secured by Treasuries.

The most comprehensive of the rates, to be called the Secured Overnight Financing Rate (SOFR), would be a broad measure of overnight Treasury financing transactions and was selected by the Alternative Reference Rates Committee as its recommended alternative to U.S. dollar LIBOR. SOFR would include tri-party repo data from Bank of New York Mellon (BNYM) and cleared bilateral and GCF Repo data from the Depository Trust & Clearing Corporation (DTCC).

“SOFR will be derived from the deepest, most resilient funding market in the United States. As such, it represents a robust rate that will support U.S. financial stability,” said Federal Reserve Board Governor Jerome H. Powell.

Another proposed rate, to be called the Tri-party General Collateral Rate (TGCR) would be based solely on triparty repo data from BNYM. The final rate, to be called the Broad General Collateral Rate (BGCR) would be based on the triparty repo data from BNYM and cleared GCF Repo data from DTCC.

The three interest rates will be constructed to reflect the cost of short-term secured borrowing in highly liquid and robust markets. Because these rates are based on transactions secured by U.S. Treasury securities, they are essentially risk-free, providing a valuable benchmark for market participants to use in financial transactions.

Comments on the proposal to produce the three rates are requested within 60 days of publication in the Federal Register, which is expected shortly.

Fed Holds Rate, Confirms Intent

The latest statement from the FED says the US economic momentum continues, if but slowly. Inflation and income remains on the low side. So they kept the fed funds rate at current levels, but signalled continued future rises. Balance sheet normalisation has yet to start, but says it will commence.

U.S. stocks closed higher, buoyed by strong earnings and the Feds decision.

Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined. Household spending and business fixed investment have continued to expand. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

For the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.

 

Understanding Banking from the Ground Up

From The St. Louis Fed On The Economy Blog.

Weak U.S. family balance sheets have driven more Americans to the “fringe” of the American banking system. But is this necessarily a bad thing?

The Federal Reserve’s Board of Governors recently released a shocking report showing that, if confronted with an unanticipated $400 expense, nearly half (44 percent) of Americans would have to sell something, borrow or simply not pay at all.1

Other surveys have been equally concerning:

This balance sheet fragility, especially illiquidity, is fueling the demand among Americans—and clearly, as the above data suggest, among middle-class Americans—for “alternative” financial services, including those from payday lenders, auto title lenders, check cashers and the like.

But should we be too critical of their financial choices? Is patronizing an alternative provider necessarily a poor or irrational choice? And do we ban payday lenders and the like because of annual percentage rates that are often in excess of 300 percent?

A Conversation with Lisa Servon on Unbanking

I wrestled with these questions following a recent St. Louis Fed event titled “The Banking and Unbanking of America”—featuring Lisa Servon, author of The Unbanking of America: How the New Middle Class Survives—and I think the answer to these questions is no.

Servon wondered: If these services are so bad, why have check-cashing transactions grown 30 percent between 1990 and 2010 while payday lending transactions tripled between 2000 and 2010?

According to Servon, it turns out that banks (with a growing number of encouraging exceptions) haven’t been serving these customers well, including charging more and higher fees for account opening, maintenance and overdrafts. Meanwhile, struggling consumers are turning to alternative providers (as well as to community development credit unions) because they value:

  • Greater transparency (with actual costs clearly displayed like signs in a fast-food restaurant)
  • Better service (including convenient hours, locations and friendly, multilingual staff)

What I really liked is that Servon—an East Coast, Ivy League academic—didn’t just arrive at these conclusions by only reading reports and talking to experts. She actually became a teller at both a payday lender in Oakland, Calif., and a check casher in the South Bronx, N.Y.

Mapping Financial Choices

I also like that several of my Community Development colleagues here at the St. Louis Fed have embraced this community-driven understanding of financial decision-making as well through a “system dynamics” research study, which maps the actual factors that influence the financial choices consumers make.

Like Servon’s work, the forthcoming version of this study will focus less on the narrow “banked/unbanked” framework and more on the broader, CFSI-inspired idea of “financial health.”

Other Areas to Address

Beyond adopting the financial health framework, Servon also suggests rethinking the government/banking relationship and supporting smart regulation so financial innovation or risk taking can thrive with some protections.

Most importantly, in my view, she recommends addressing the macro problems—for example, flat or declining real wages, less full-time and stable employment, and weaker unions—that underlie the demand for the immediate cash that alternative providers offer so well, albeit not so cheaply.

But it’s also true that weak balance sheets—the micro—contribute to the macro problem: Strapped consumers just don’t spend as much. So, we really must address both.

Notes and References

1Report on the Economic Well-Being of U.S. Households in 2016.” Board of Governors of the Federal Reserve System, May 19, 2017.

2 Gutman, Aliza; Garon, Thea; Hogarth, Jeanne; and Schneider, Rachel. “Understanding and Improving Consumer Financial Health in America.” Center for Financial Services Innovation, March 24, 2015.

3The Precarious State of Family Balance Sheets.” The Pew Charitable Trusts, January 2015.

Author: By Ray Boshara, Senior Adviser and Director, Center for Household Financial Stability

Who Would Be Affected by More Banking Deserts?

From The St. Louis Fed On The Economy Blog.

Although technology has made it easy to bank from almost anywhere, personal and public benefits are still derived from bank branches. In areas without branches—commonly referred to as “banking deserts”—the costs and inconveniences of cashing checks, establishing deposit accounts, obtaining loans and maintaining banking relationships are exacerbated.

Banking Deserts a Growing Concern?

The closing of thousands of bank branches in the aftermath of the last recession has intensified societal concerns about access to financial services among low-income and minority populations, groups that are often affected disproportionately in such situations. The number of people stranded in areas devoid of bank services would probably expand in the future if branches continue to close.

From this perspective, available resources may be better spent trying to prevent more deserts than trying to repopulate existing deserts with new branches.

What Areas Are at Risk?

In the figure below, we isolated branches that were outside the 10-mile range of any others. That is, we found branches that would create new banking deserts if closed. Our analysis is based on demographic and economic data collected for the county subdivision in which each branch is located.

Banking Deserts

We identified 1,055 potential deserts in 2014, of which 204 were in urban areas and 851 in rural areas. The urban areas had a combined population of 2 million, while the rural areas had a combined population of 1.9 million.

These potential deserts have relatively low population densities of 26 people per square mile in urban areas and 12 people per square mile in rural areas. Comparative densities outside potential deserts are, respectively, 176 and 26 people per square mile. In other words, areas with dispersed populations are more at risk of becoming a banking desert.

Potential Effects of New Banking Deserts

Median incomes are $46,717 in potential urban deserts and $41,259 in potential rural deserts. This suggests that any desert expansion would affect lower-income people more than higher-income people.

Minorities constitute 9.8 percent of the population in potential urban deserts and 4.0 percent of the population in potential rural deserts. Both percentages are lower than those for existing deserts and nondeserts. This suggests that newly created deserts may not disadvantage minorities to a greater extent than existing deserts do.

Branches in potential deserts are small, with median deposits of $23 million in urban areas and $20 million in rural areas. They tend to be operated by small banks, with median total assets of $776 million in urban areas and $317 million in rural areas.

The small size of these branches and the banks that own them suggest that what stands between a community and its isolation within a new banking desert are not the decisions made by big banks with a national footprint but, rather, the decisions made by locally oriented community banks. Additionally, potential deserts are more likely to be located in Midwestern states.

The Market’s Expectations about FOMC Meetings

From The St. Louis Fed On The Economy Blog.

There are eight scheduled Federal Open Market Committee (FOMC) meetings each year. However, not all FOMC meetings are created equal. A prescheduled press conference follows four of the eight meetings (those held in March, June, September and December in 2017). This allows the chairperson to present the FOMC’s current economic projections and provide additional context for policy decisions.

Many believe that the FOMC prefers to make policy changes at meetings with a press conference because the opportunity for communication reduces uncertainty in the markets. A brief examination of the data suggests that markets hold this belief.

The Federal Funds Rate Target

The federal funds rate target is an important policy tool controlled by the FOMC, allowing it to influence short-term and long-term interest rates. As the FOMC continues the rate hike cycle it began in December 2015, future target rates are the subject of much speculation by market participants.

Using federal funds rate futures, projections of future target rates are computed each trading day. The figure below plots the market estimates of rate increases at future FOMC meetings following the Jan. 31-Feb. 1 meeting, which affirmed a target range of 0.5 to 0.75 percent.

rate hike probability

The orange line indicates the probability that the federal funds rate target is between 0.75 to 1.0 percent at the March meeting for each trading day between Jan. 31 to March 14, the date of the March meeting.

For example, on Feb. 1, the market gave a 28.8 percent chance that the target would be at 0.75 to 1.0 percent at the March meeting. Given that the next meeting as of Feb. 1 was the March meeting, the 28.8 percent was indeed the rate hike probability for the March meeting.

Similarly, the blue line plots the same probability for May. On Feb. 1, the market gave a 35.9 percent probability that the target would be at 0.75 to 1.0 percent after the May meeting.

However, the May meeting would be the second meeting after Feb. 1, so the interpretation of this 35.9 percent probability is slightly different. It represents the probability of a rate hike at either the March meeting or the May meeting.

Market Expectations of Rate Increases

Does the market expect the FOMC to change the federal funds rate target only at meetings accompanied by a press conference? We can answer this question by comparing changes in the market’s projection between two consecutive meetings.

Let’s first compare the market’s expectation between the press conference meeting in March and the nonconference meeting in May.

The March and May FOMC Meetings

As discussed earlier, the orange line indicates the rate hike probability for the March meeting, and the blue line indicates the rate hike probability for the March or May meeting. Hence, the difference between these two probabilities can be thought of as the probability of a rate hike only at the May meeting.

If the market expects that the federal funds rate target can only be changed at the conference meeting in March and remain the same at the nonconference meeting in May, then we should see that the orange line and the blue line follow each other closely until the date of the March meeting with a difference that is close to zero.

This is exactly what we observe. Right before the March meeting, both probabilities approached 100 percent, indicating that the market expected a rate hike at the March meeting followed by no change at the nonconference meeting in May.

The May and June FOMC Meetings

Similarly, we can compare the rate hike probabilities between the nonconference meeting in May and the press conference meeting in June, which are indicated by the red line and the purple line:

  • The red line represents the rate hike probability for the May meeting.
  • The purple line indicates the rate hike probability for the May meeting or the June meeting.

Hence, the difference between the lines indicates the probability of a rate hike at the June meeting only.

The red line suggests that the probability of a rate hike at the May meeting is essentially zero after the March meeting occurred. Given that the market assigned a rate hike probability of zero for the May meeting, the rate hike probability for the June meeting is essentially equal to the probability indicated by the purple line. It started around 50 percent right after the March meeting and gradually approached 100 percent right before the June meeting. This is additional evidence that market participants expect rate hikes to occur only at the conference meetings.

Effects of FOMC Press Conferences

The market seems to believe that important policy changes can only be done at meetings accompanied by a press conference. If that is the intention of the FOMC, then the role of these nonconference meetings becomes ambiguous. In addition, if economic conditions change enough that a policy response is required at a nonconference meeting, should the FOMC pursue the policy change or wait until the next meeting with a press conference? If this is not the intention of the FOMC, should the FOMC consider equalizing the meetings to correct the bias expected among market participants?

How Trump’s nominee for the Fed could turn central banking on its head

From The Conversation.

President Donald Trump on July 10 nominated Randal Quarles to be one of the seven governors of the Federal Reserve System, the central bank of the United States.

Before I get to Quarles and his qualifications, it’s important to understand the Fed and what it does. Its decisions are vital to every person on the planet who borrows or lends money (pretty much everybody) since it has enormous influence over global interest rates. Its board of governors also influences most other aspects of the global financial system, from regulating banks to how money is wired around the world.

Quarles, for his part, is clearly qualified for a job at the pinnacle of financial regulation. He has held numerous positions in the U.S. Treasury Department, including undersecretary for domestic finance under George W. Bush, and was the U.S. executive director at the International Monetary Fund (IMF). He has also worked on Wall Street for The Carlyle Group and founded his own investment company, The Cynosure Group. He also has a law degree from Yale.

The issue that I believe deserves careful scrutiny, however, does not involve his qualifications. Rather it’s a view of his that, if allowed to permeate the Fed, would represent a seismic shock to how the central bank operates and could potentially have severe consequences if – or when – we stumble into another financial crisis like the one we endured only a decade ago.

Trump Fed nominee Randal Quarles, left, talks with then-central bank Chair Alan Greenspan in 2002. Reuters/Hyungwon Kang

How the Fed controls the world

Currently, the Fed rules the financial world using a very simple model: A handful of very smart people sit together at least eight times a year and decide how to execute the country’s monetary policy.

The implications are enormous. In the words of the Fed itself, decisions made in these meetings:

“trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit and, ultimately, a range of economic variables, including employment, output and prices of goods and services.”

Janet Yellen currently chairs this group, called the Federal Open Market Committee (FOMC), and its decisions, like those of the Supreme Court, are final. There are few or no absolute rules, and there is no appeal.

Quarles, however, has described the discretionary decisions of this small group as “a crazy way to run a railroad.”

Instead, Quarles argues that the Fed should use a rules-based approach, with little or no discretion. Economic data would be plugged into a simple model, which would spit out the decision the Fed should take.

Since the model would be well-known and the relevant economic data (such as GDP, inflation rates, etc.) are already widely publicized, everyone from Wall Street to Main Street who cares about interest rates would be able to predict how the Fed is going to react under such a rules-based approach.

The Taylor rule

While Quarles has not specifically referred to which rule he would favor, a frequently cited one is called the “Taylor rule.”

It is named after Stanford economist John B. Taylor, who proposed it in 1993 as a new guiding principle for central bank decision-making. In recent years, the rule has gained much interest among people who watch and study the Fed.

The Taylor rule states that the Fed should establish short-term interest rates using a mathematical formula. It would use the current rate as a starting point and then factor in data tied to inflation and GDP, both based on the difference between the actual figures and the bank’s targets.

John Taylor created his eponymous rule to guide central bank decision-making. AP Photo/Ted S. Warren

Inflation is an important variable because price changes impact people’s standard of living, while GDP growth affects the number of jobs available in the economy.

Since it would rely on a few human inputs from the Fed, the Taylor rule is somewhat flexible, enough to accommodate different situations by allowing central bankers to specify the importance of inflation compared with GDP growth.

Some countries, like Germany, primarily focus on keeping inflation extremely low. Others, such as the U.S., try to balance both inflation and GDP growth roughly equally. Central banks in some developing countries like those in Africa often put stronger emphasis on boosting economic growth with less regard to inflation.

But that’s about as far it will stretch.

Why does this matter?

In general, the Taylor rule would lead central banks to increase interest rates when inflation is high or when unemployment is very low. Conversely, the rule indicates central banks should lower interest rates when inflation is too low (or there is deflation), when economic growth is poor or unemployment is climbing.

But therein lies the rub. Rules work well when things are “normal,” but when the unexpected happens, they become much less useful – even harmful.

If the Taylor rule were an effective and straightforward method of transforming complex choices into simple, easy-to-understand decisions, the question is, why doesn’t every central bank use this rule?

The answer is as simple as the Taylor rule itself. Sometimes a country faces an economic quandary, such as what the U.S. experienced during the oil price shocks of the late 1970s. Back then, inflation was too high and GDP growth was too low, leaving the country stuck in what is known as a period of stagflation.

In these circumstances, the Taylor rule breaks down. It tells central bankers there is nothing they can do to improve economic conditions. The rule signals that interest rates need to be raised to combat high inflation, yet at the same time that would weaken already-sluggish GDP growth.

Had the U.S. followed the Taylor rule back then, it would have done nothing. Instead, the Fed raised interest rates and broke the back of inflation expectations.

What’s crazier

Simply put, central bankers around the world – including those at the Fed – have not adopted rules-based monetary policy using the Taylor rule or another because in times of economic crisis, a simple precept usually fails to provide effective solutions.

The current ad-hoc approach provides maximum flexibility and allows central bankers to reach for untested methods that help them get the economy back on track.

Quarles may be right. It might be a crazy way to run a railroad. But then again, monetary policy – and the US$18.6 trillion U.S. economy – is a bit more complex than operating a train on a set of rails. The crazy thing might be to do it any other way.

Author: Jay L. Zagorsky, Economist and Research Scientist, The Ohio State University

Fed Will Lift Rates, And Remove Funding Support

The Federal Reserve Board and the Federal Open Market Committee released the minutes of the Committee meeting held on June 13-14, 2017.

They are expecting the benchmark rate to continue to rise, as inflation normalises.

They also provided more colour around the normalisation of the balance sheet. This will have significant market impact.

All participants agreed to augment the Committee’s Policy Normalization Principles and Plans by providing the following additional details regarding the approach the FOMC intends to use to reduce the Federal Reserve’s holdings of Treasury and agency securities once normalization of the level of the federal funds rate is well under way.

The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.

  • For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
  • For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at threemonth intervals over 12 months until it reaches $20 billion per month.
  • The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

Gradually reducing the Federal Reserve’s securities holdings will result in a declining supply of reserve balances. The Committee currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.

The Committee affirms that changing the target range for the federal funds rate is its primary means of adjusting the stance of monetary policy. However, the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate.

Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.