The Flaw At The Heart Of The Fed's Path To Policy Normalization
Investing.com | Feb 19, 2018 03:15AM ET
- Yellen’s track record is a tough act to follow
- Powell is left with the responsibility of further policy normalization
- “Over-communication” in current policy may be Fed’s fatal flaw
If stock markets were to be considered the measure of choice for determining quality of performance at the helm of the Federal Reserve, recently appointed chairman Jerome Powell had a rough first week. Powell's tenure as Fed chair began on February 5 amid extreme market turmoil; both the Dow and S&P 500 fell 5.2% during the course of that week, their worst weekly performance since January 2016.
“I didn’t have a computer on my first day at LPL, and I thought that was bad,” LPL Research senior market strategist Ryan Detrick commented . “Well, Jerome Powell saw the single worst first day ever for a Fed chair when the Dow dropped 4.6% on Monday—I’d say that’s a bad first day on the job!”
Yet little should be read into the rough welcome for Powell as, according to Detrick’s numbers, the Dow has a tendency to slide more than 15% on average within the first six months of new Fed leadership. However, this strategist also noted that the average rebound for the Dow in a year after hitting those six month lows is equivalent to 20%.
Former Fed chair Janet Yellen ended her reign at the central bank with a stunning track record—including stock market gains and a significant drop in unemployment—leaving a tough act for Powell to follow as he picks up the baton of policy normalization.
Although Yellen was able to smoothly guide both the U.S. economy and stock markets through the process of jump-starting the removal of accommodation, she may well have left her successor with a legacy of monetary policy strategy that planted the seeds for the next big market upset.
h3 Yellen’s Stellar Track Record Only Kick-Started Policy Normalization/h3When Yellen took the helm of the Fed on February 3, 2014, the unemployment rate was at 6.7%. As she left her office, the jobless rate was at 4.1%, the lowest level since 2000. That's also the lowest final unemployment rate of any Fed chair since William Martin in 1970. Plus, the 2.6 percentage point drop from start to finish is the largest in the tenure of any Fed chair in the post-World War II era. Number two on the list, Alan Greenspan only managed a 1.3 percentage point drop and his longer reign saw no smooth sailing with the level hitting nearly 8% in the early 1990s.
Investors in stocks would arguably do well to applaud Yellen with the S&P up 55% (see chart below) and the Dow pocketing gains of nearly 63% during her four years at the head of the U.S. central bank.
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Chart: S&P 500’s run during Yellen’s term as Fed chair
After taking the wheel from her predecessor Ben Bernanke, Yellen led the Fed full fledge into its task of removing extraordinarily accommodative monetary policy in an attempt to return to policy normalization.
Though nearly two years after her appointment, on December 16, 2015, the Federal Reserve, under Yellen’s lead, increased its key interest rate for the first time since 2006, in what would be the first of five 25 basis point hikes before her term ended.
Although tapering of its asset purchase program began in December 2013, just before Yellen took over the Fed, it wasn’t until October 2014 that the monetary authority announced the actual “end” of its bond-buying program. Yet still, the balance sheet was not being reduced as proceeds on principal and interest payments were reinvested. As part of its plan for quantitative easing, it’s holdings of Treasuries and mortgage backed securities had ballooned from around $800 billion at the end of 2007 to $4.5 trillion as the monetary authority struggled to align the American economy on a stable path throughout the financial crisis.
Fed balance sheet in millions of dollars. Source: Federal Reserve
However, during March 2017 the Fed signaled that it would begin to reduce its balance sheet later in the year, by no longer rolling over the proceeds for reinvestment, and it was just last September that the first woman to lead the U.S. central bank launched the plan to begin unwinding the Fed’s massive holdings in October. Still, that reduction will be a slow process with the runoff calculated to be only about $300 billion in 2018, or a mere 8.1% of all assets purchased since the financial crisis.
h3 Powell Takes The Helm To Undo ‘Abnormal’ Policy/h3Powell is widely expected to continue with the process kick-started by Yellen in a gradual tightening of monetary policy. The now former Fed governor has never dissented from a policy decision since he joined in 2012 and is widely described as fitting into the dovish camp. Such are expectations that Powell will continue the Yellen legacy that some on Wall Street have reportedly referred to him as “Janet-lite”.
Apart from being expected to follow in Yellen’s footsteps, Powell is inheriting an already healthy economy but with a monetary policy stance that is still far from “standard” as he runs the difficult task of trying to steer back to policy normalization after 10 years of liquidity- addicted markets.
Subdued price pressures continue to be a conundrum for the Fed, with wage inflation largely lagging projections despite an economy that appears to be if not at, then very close, to full employment.
Indeed, the heads of both the Chicago and Minneapolis Feds, Charles Evans and Neel Kashkari, respectively, voted against the last rate hike in December, arguing that inflation needed to move closer to the 2% target before proceeding with further tightening.
Meanwhile, policy normalization’s end goal still remains far beyond the horizon. The process of shrinking the Fed balance sheet is underway but is calculated to take several years at the current pace, even assuming there are no unexpected bumps in the road. Although the Fed could sell off its holdings to speed up the pace, markets are betting that it will simply allow them to run off at maturity as part of the current “gradual” process.
Furthermore, markets seem to have all but forgotten that the current target range for the Federal Funds Rate is far from the realm of “normal”* monetary policy. Forecasts for future interest rate levels from the current 1.25% to 1.50% continue to include that 25 basis point range between the upper and lower bound, a product of the policy move made back in December 2008.
*By “normal”, we refer to not only the single target rate instead of the 25 basis point range, but also to the fact that, as can be seen in the chart below, interest rates remain at historically low levels.
In the transcripts from that historic discussion at the heart of the U.S. monetary authority nine years ago, St. Louis Fed president James Bullard voiced his thoughts on an eventual return to normalization after implementing the range:
“Once the crisis is past, then we can begin setting a Federal Funds target again, maybe coming back with a range initially for the Federal Funds Rate and then gradually moving back into the targeting regime, which I agree in normal times is a much better way to communicate policy.”
Five hikes into the process begs the question of when the Fed, now led by Powell, will consider that “normal times” have returned.
h3 Over-Communication: Fed’s Fatal Flaw?/h3Lastly, markets have arguably become accustomed to expect “over-communication” from the Fed. While traders still go over each Fed statement with a magnifying glass, scouring the document for the minute language changes that could provide additional clues to the future policy path, the Fed has embarked on a task to telegraph the actual changes to interest rates well in advance, with policymakers giving clear indications of their intentions at almost every opportunity between meetings.
This may well have been the result of Yellen’s first post-decision press conference in March 2014 where stock markets sank after interpreting her words to imply that policy tightening was imminent. Yellen appeared to “take the hint”, becoming extremely cautious in her public remarks while at the same time emphasizing clear clues to prepare markets for future moves.
One of the effects of this strategy can be seen in the latest string of rate hikes where Fed Fund futures pushed the odds for a 25 basis-point hike to well above 90% in the days leading up to each meeting, making the actual announcement anticlimactic. The next 25 basis-point increase is expected to occur at the March 20-21 meeting and—if recent history repeats itself and barring economic data surprises—one would expect the odds to continue to edge even closer towards the 100% mark as the two-day meeting nears.
The Fed’s increased focus on guidance has left its footprint on market expectations. The U.S. futures market is now pricing in roughly four additional rate hikes through January 2020, as noted by PIMCO’s global strategist Gene Frieda in a recent blog post .
“This is the first time since the Federal Reserve began publishing its ‘dot plot’ (a projection of where it expects the policy rate will be in the long run) that market pricing has caught up with the Fed,” he pointed out.
However, the Fed may well be painting itself into a corner in its efforts to telegraph its intentions. Despite policymakers’ objections to the contrary, market participants have taken for granted that the Fed can only make a move in a meeting with a follow-up press conference.
So far, the central bank has dutifully followed that script, boxing itself into just four meetings—March, June, September and December—of the eight held each year where it can make a policy move without turning financial markets on their heads.
While this policy path of over-communication may be relatively easy to handle in a framework of gradual tightening to obtain policy normalization, it runs the risk of becoming the Fed’s fatal flaw when “normalcy” does return and the central bank finds itself faced with the need to act without having had the chance to give markets a preview.
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