Much Ado About Neutral
Here we are - yet another high NFP and CPI print - and clamors of Fed not being hawkish enough are followed up with a WSJ article of possibility of 75bp hike. Just when you think the Fed has the messaging under control, there is yet another plot twist.
There are 3 elements of a tightening cycle that the central bank can use to communicate its intent - starting date, pace and terminal rate. The Fed first stepped up its hawkish reaction function by pulling forward the start date of its first hike to March and then escalating the tightening pace up to 50bp in May. However, the Fed seems to be weighted down by the albatross hanging around its neck of its estimate of neutral funds rate. The idea that policy rate getting to neutral rate implies a point of reassessment has been a theme across multiple Fed speeches. In my opinion, this line of thinking has led to a dilution of the Fed's stated intent to 'do whatever it takes' to bring inflation down.
In my opinion, the Fed's focus on referring to longer run neutral rate in determining policy path is flawed for multiple reasons -
In the current environment where macroeconomic volatility is extraordinarily high and inflation is well above target, the concept of long run neutral rate should have little bearing on near-term policy setting. The neutral rate estimate itself has a wide band and the short run neutral can often be quite different than the long run neutral. These points were clearly articulated by Powell and Brainard during the 2018 cycle. Specifically, Powell highlighted risks of relying on these in calibrating policy can result in adverse outcomes for the Fed.
"The risks from misperceiving the stars also now play a prominent role in the FOMC's deliberations. A paper by Federal Reserve Board staff is a recent example of a range of research that helps FOMC participants visualize and manage these risks.The research reports simulations of the economic outcomes that might result under various policy rules and policymaker misperceptions about the economy. One general finding is that no single, simple approach to monetary policy is likely to be appropriate across a broad range of plausible scenarios.19 More concretely, simulations like these inform our risk management by assessing the likelihood that misperception would lead to adverse outcomes, such as inflation falling below zero or rising above 5 percent." - Chairman Powell, Aug 2018.
"Focusing first on the "shorter-run" neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions." - Gov. Lael Brainard, Sep 2018
The long lags with which monetary policy impacts the economy seems to have been lost in translation. Constraining its policy path by indicating resistance to moving much above the neutral rate, the hyper-sensitivity to monthly inflation data has manifested itself in pushing the Fed to accelerate the pace of its tightening path. This increases the odds of a financial market accident which might in the end prove to be counterproductive to the Fed's inflation fighting credibility.
The Fed has deployed both policy rates and balance sheet in easing and is doing the same during the tightening process. The level of neutral rate is not independent of the size of the balance sheet relative to normal. While the balance sheet is well above any estimates of normal, overly relying on long run neutral rate estimates in setting policy in the near-term increases risks of making a policy mistake.
In my opinion. the concept of neutral funds rate is incomplete and arguably misleading. In fairness, policymakers and market participants use the concept of financial conditions in conjunction with neutral funds rate in assessing policy paths. But while neutral funds is a level-based concept, financial conditions is more typically a change-based concept and harder to compare across periods. In my view, a 'neutral cost of capital' which combines the two concepts is a better measure to use in thinking about appropriate policy setting that could be compared across time. My simplistic formulation for this is -
Neutral Cost of Capital (C*) = (0.45 x BAA Yield + 0.45 x SPX Fwd Earnings Yield + 0.1 x 30Y Mortgage Rate)
The weights represent relative proportion of market capitalization of these assets.
Although this simplistic measure certainly lacks some of the elements of FCI like energy prices and FX rate, even on this formulation, the Fed isn't as far behind the curve and has got the cost of capital towards the higher end of the post-GFC range (5% - 6%). Given the inflation dynamic it is quite likely that they need to take it higher back into the range that existed pre-GFC (6 - 8%). In my opinion, formulating the neutral policy setting in a cost of capital construct (which I'm certain the Fed staff have a more sophisticated version than my simple forumation) would improve Fed communication on required terminal policy rate as it would account for policy needing to do more when financial conditions are easy and to do less when they are not.
At the risk of sounding preachy which is easy to do from the cheap seats that I sit in, I think the Fed communication could do with some changes -
In an environment where macroeconomic volatility is high and inflation is significantly above target, there are no quick fixes to this problem. The Fed communique on its policy path should emphasize that and frame its firm resolve to bring inflation to target in context of a longer time horizon as opposed to the next meeting or two.
The Fed would be better served by acknowledging that appropriate terminal rate in this cycle has a wide distribution and that they will know when they get there. Powell's comment on 'we're a long way from neutral' which caused an uproar in markets in 2018 might be more appropriate today.
Fed should indicate that the appropriate policy response remains to tighten policy by at least 50bp increment at every meeting (not just the next couple) until there is sufficient and convincing evidence that inflation pressures are receding. The policy path needs to be characterized as a deliberate data-dependent multi-meeting plan as opposed to a panic reaction to the latest data print.
Fed needs to drive home the point that sustaining tight policy for a period is necessary to bring inflation down and it is a reasonable probability that rates could end up being much above long run neutral. That does not constitute a policy mistake but rather is the explicit intent.
Lastly, deliver the message that once the inflation problem is dealt with decisively, the committee will have the flexibility to calibrate policy lower if necessary to support its dual mandate on an on-going basis.
A clearly articulated medium term plan of action would boost its credibility as opposed to letting the market dictate appropriate Fed policy on a meeting-by-meeting basis based on the latest set of data. Bond market vigilantes play an important role in forcing policymakers to act responsibly but they shouldn't be taking on the role of being the policymakers.