Getting off zero in December, Yellen promised a very gradual tightening cycle. All concerned agreed that rates would remain “low for longer.” Just how low and for how long was the real question and on that question there was substantial disagreement between the Fed and the bond market. After the lift-off, the market was pricing in no more than two quarter-point hikes in 2016, even as 10 of the seventeen participants of the Federal Open Market Committee expected at least four hikes and only 4 expected no more than two. By March, participants’ expectation profile, as revealed by the Fed’s dot plot, had reversed. Now 4 of the seventeen expect at least four hikes and 10 expect no more than two. The disagreement between the Fed and the bond market has been partially resolved by the Fed’s capitulation.
Make no mistake: The reversal amounts to a significant easing of monetary policy. The expected path of the federal funds rate is as important as the federal funds rate itself, if not more so. A lower expected path pushes down the entire yield curve, increasing the value of all bonds; and as investors get pushed out along the risk curve in search of yield, of other financial assets as well. In turn, higher assset prices strengthen the balance sheets of households, firms and banks; resulting in greater willingness of households to spend, firms to invest and hire, and banks to lend, thereby boosting economic activity. Indeed, the monetary effect of a shallower expected path of the federal funds rate is identical to that of quantitative easing: Both push down the yield curve, bouy up asset prices and rely on the attendant wealth effect to stimulate economic activity.
Moreover, the policy shift was not priced in before the announcement, which is why the yield curve flattened and the dollar weakened as expectations of policy divergence between hard-currency issuing central banks got priced out. Contrast that to the December announcement when bond yields barely budged at all. Since asset prices incorporate market expectations at any given time, only unexpected developments—above all policy surprises—result in a major repricing of assets.
With the unemployment rate steady at 4.9% and core PCE inflation at 1.7% (up from 1.5% in December), the Fed is arguably well on track to deliver on its congressionally mandated goal of maximal employment consistent with price stability. So why the volte-face? Why is the Fed suddenly in full easing mode?
The Fed is worried about two things: Worsening financial conditions and the risk of inflation expectations getting deanchored.
Although high-yield credit spreads have eased somewhat in the past month, they remain extraordinarily elevated. (See Figure 1.) High-yield spreads reflect the higher cost of borrowing of lower-rated firms. When they are elevated, firms find it hard to invest in productive capacity and hire workers. The last time high-yield spreads were this high was during the financial crisis. And before that, in the aftermath of the bursting of the tech bubble.
Figure 1: High-Yield Credit Spreads and Breakeven inflation.
Source: Federal Reserve Bank of St Louis
Figure 1 also presents a key measure of breakeven inflation, the 5-Year, 5-Year Forward Inflation Expectation Rate. As a measure of inflation expectations, it is robust to transitory shocks (for instance, oil price shocks), and reflects underlying long-run inflation expectations. If the market expects the Fed to deliver on its inflation target of 2 percent, then it should remain at or slightly above the Fed’s target. It is therefore a key barometer of the Fed’s credibility on inflation.
Breakeven inflation declined dramatically during the bout of late-August volatility. It then dithered at that level for the rest of the year. When volatility returned to global markets in the new year, it fell off a cliff. Despite recovering somewhat in the past month, at 1.7 percent, it is significantly lower than its long-term average of 2.4 percent. Indeed, the only other time it has remained below 2 percent for months at end was during the Great Recession!
Yellen was trying to put on a brave face. The judgment of the bond market is quite unambiguous. There is a material risk of long-term inflation expectations getting deanchored. Since expected inflation itself plays a key role in wage and price setting, the deanchoring of inflation expectations would compromise the Fed’s ability to deliver on its inflation target. Think Japan.
More generally, since the December meeting, financial markets have displayed a significant amount of stress. Figure 2 displays the Cleveland Fed’s Financial Stress Index.
Figure 2: Cleveland Fed’s Financial Stress Index
Again we see the same dynamic: Two months of heightened stress following the bout of late-August volatility, then a couple of months of ease, followed by a dramatic return of stress in the new year. Worryingly, the Index has been at this level or worse only during periods of panic: the financial crisis, the eurozone crisis, following 9/11, and during the dot com bust.
Given the degree of financialization of the US economy, the Fed is afraid that worsening financial conditions would work their way back into the real economy, as indeed they would. It did not come out and say so explicitly, but it has clearly decided that the balance of risks has shifted dramatically since the December hike; a decision that looks increasingly ill-judged.
Meanwhile, the bond market is one step ahead of the Fed. According to the futures market, there is a seventy percent chance that there will be no more than one hike this year.
Anusar has a Phd in Mathematics and lives in New York. He writes under the pseudonym Policy Tensor.