It was late in 2018 and the Fed was tightening, the market was pricing in a federal funds rate of close to 3%; 10-year U.S. Treasury yields were heading toward 3.5% and tighter financial conditions, and markets began adjusting aggressively. In 2018, there were real yields in tow.

The Fed’s ultimate reaction function: broader financial conditions

In the fall of 2018, market participants urged the Fed to abandon its tightening campaign from 2015, accelerating with market-based inflation expectations running above the Federal Reserve’s 2% symmetric inflation target under their old framework of Flexible Inflation Targeting, which had been adopted in 2012. Fiscal forces were in play for the first time, in a long time.

Here’s some additional perspective in the evolution of the Fed’s thinking; 2012 was the first step toward Flexible Averaging Inflation Targeting (FAIT) that we have today.

Overnight Index Swaps (FF), U.S. 10-year yields and the Credit Default Swap Index (2016-2020)

“This” Fed

This is not the same Federal Reserve from even just five years ago. the mindset changes began in 2018 when Jay Powell took over as Chairman of the Federal Reserve and more importantly were seeded when Richard Clarida was appointed by President Trump, succeeding Stanley Fisher as Vice Chairman in April of 2018.

The mindset is real and the Fed “will do whatever it takes for as long as it takes. Not thinking about thinking about raising rates.” This is a pandemic that lines up with a pre-existing mindset.

The Fed Listens in 2018

The Fed Listens program was the cornerstone of the recent framework changes coming out of the annual Jackson Hole summit.

Chairman Powell was clear in his July 2020 press conference:

“The Fed’s been acting on these changes all along” since early 2019; we agree.

The Fed Listens report from June 2020 Perspectives from the Public. It was the last summary before Jackson Hole with one last symposium to include coronavirus; thoughtful, Fed.           

From the Federal Reserve in the fall of 2018:

“The Federal Reserve on Nov. 15, 2018, announced a review of the strategy, tools, and communication practices it uses to pursue its congressionally assigned mandate of maximum employment and price stability. The Committee is expected to report its findings in 2020.”

AmeriVet’s weekly Rates in Review via LinkedIn on June 5, 2019:

 “Over the past several months the Fed has spent considerable time discussing a sustained flattening of the Phillip’s curve, lower neutral rates and the risk of lower sustained inflation expectations. Both Chairman Powell and Clarida highlight these themes in their most recent speeches, and the effort and time within the marketplace, is telling and will likely bring policy changes heading into 2020.”

 Vice Chairman Richard Clarida, following Jackson Hole in August 2020:

“This is a robust evolution in the Federal Reserve’s policy framework and, to me, reflects the reality that econometric models of maximum employment, while essential inputs to monetary policy, can be and have been wrong, and, moreover, that a decision to tighten monetary policy based solely on a model without any other evidence of excessive cost-push pressure that puts the price-stability mandate at risk is difficult to justify.”

Perspective

The Federal Reserve was in a transitional year in 2018. With all the discussion around programs and actions taken by the Federal Reserve in the past six months, we find it relevant to go back in time. Yet, not far back in time for answers to the current changes to the Federal Reserve’s Policy Statement of Longer-Run Goals and Strategy.

The Federal Reserve was established in 1913, emanating from the Federal Reserve Act. Without question, many of the programs we are witnessing today reference this, more specifically Section 13(3), which is a very familiar phrase we have heard from Chairman Powell and Treasury Secretary Mnuchin since the pandemic began:

“This world changed. And we believe reference points matter more than ever. This paper is not about those specific changes, but it does drive our thought process and analysis. We are of the belief that history will say: globalization, in conjunction with the evolution of technology, social media and aging population over the past 25 years, were the driving forces that moved global central banks to embrace a negative to zero interest rate pathway. The United Kingdom is on the cusp of joining the negative rate initiative and the US consumer has been the critical crutch the Fed holds.”

The real neutral interest rate

With the discussion of late around the recent Federal Reserve framework changes, there has been much discussion around the neutral interest rate.

The neutral rate of interest, also called the longer run equilibrium interest rate, the natural rate or to the Fed, r-star (or r*). It is the short-term interest rate that “would” prevail when the economy is at full employment and stable inflation; the rate at which monetary policy is neither contractionary nor expansionary and a function of the economy’s underlying characteristics.

Dallas Federal Reserve President Kaplan, current voting member, in 2018:

“You won’t find the neutral rate quoted on your computer screen or in the financial section of the newspaper. The neutral rate is an ‘inferred’ rate—that is, it is estimated based on various analyses and observations.”

Does the real neutral rate matter?

The real rate affects how the Fed determines whether the Fed Funds rate it sets stimulates or restrains the economy.  The Fed may temporarily set the benchmark Federal Funds rate above the neutral rate to slow the economy or below the neutral rate in order to stimulate it. The neutral rate is a guiding light for monetary policy and very important.

“This” Fed’s view on the real neutral rate

With deliberate change, commitment should follow; this is true in all walks of life. So, with relation to the Federal Reserve’s most recent changes, there has been much criticism over the lack of clarity we are getting around the definition of both price stability and maximum employment. The market has priced the Fed’s stated intention to keep the federal funds rate on hold for at least three years.

To date, Fed has been very reluctant to offer arithmetic, rules or model references regarding the new framework in defining how they are viewing their dual mandate.  

A look at Chairman Powell’s Committee over time on the neutral rate; 2014 – present

Monetary Policy in Open Economies: Practical Perspectives for Pragmatic Central Bankers Richard H. Clarida, May 19, 2014:

“The neutral real interest rate, a key input to Taylor rule analysis, appears in practice to be time varying (Laubach and Williams, 2001), and this time variation is likely to be more important in the future than in the past for calibrating monetary policy.  In particular, the neutral real interest rate in the open economy will be a function of global as well local factors such as the rate of potential growth…”

Following Jackson Hole in August 2020

“Perhaps the most significant change since 2012 in our understanding of the economy is our reassessment of the neutral real interest rate, r*, that, over the longer run, is consistent with our maximum-employment and price-stability mandates. In January 2012, the median FOMC participant projected a long-run r* of 2.25 percent, which, in tandem with the inflation goal of 2 percent, indicated a neutral setting for the federal funds rate of 4.25 percent. However, in the eight years since 2012, members of the Committee—as well as outside forecasters and financial market participants—have repeatedly marked down their estimates of longer-run r* and, thus, the neutral nominal policy rate.4 Indeed, as of the most recent Summary of Economic Projections (SEP) released in June, the median FOMC participant currently projects a longer-run r* equal to just 0.5 percent, which implies a neutral setting for the federal funds rate of 2.5 percent. Moreover, as is well appreciated, the decline in neutral policy rates since the GFC is a global phenomenon that is widely expected by forecasters and financial markets to persist for years to come.”

Dallas Federal Reserve President Kaplan, dissenter at last week’s Fed meeting.

The Neutral Rate of Interest, 2018

Implications for monetary policy

Kaplan: Currently, with the U.S. unemployment rate at approximately 3.7 percent and the headline personal consumption expenditures (PCE) rate of inflation at slightly more than 2 percent, I believe that the Federal Reserve is achieving its dual-mandate objectives.

As we reach our dual-mandate objectives, I believe that the Federal Reserve should be gradually easing off the accelerator—we no longer need to be stimulating the U.S. economy. As such, I believe we should be gradually and patiently moving toward a neutral policy stance.

Kaplan: Due to improvements in expectations for near-term U.S. economic growth, estimates of the shorter-run neutral rate have risen over the past 12 months. However, because these shorter-run estimates are subject to great uncertainty and can be heavily influenced by near-term transitory factors, I tend to focus a bit more heavily on expectations for medium- and longer-term growth in the U.S. economy. As a consequence, estimates of the longer-run neutral rate weigh more heavily on my thinking.

What is the perspective on historical market-based inflation?

When looking at the chart below on inflation break-even rates, one becomes curious about what the Fed’s stance would have been during the period of 2015—2018, with the new Federal Reserve Flexible Inflation Averaging Targeting framework in mind.

Is the range okay without trajectory? Does the Fed get nervous around the upper end? 

5-year forward, 5-year Inflation Break-Even Rates

Here, we offer some perspective from a recent speech from Vice Chairman Clarida following the Jackson Hole changes in August:

“This is a robust evolution in the Federal Reserve’s policy framework and, to me, reflects the reality that econometric models of maximum employment, while essential inputs to monetary policy, can be and have been wrong, and, moreover, that a decision to tighten monetary policy based solely on a model without any other evidence of excessive cost-push pressure that puts the price-stability mandate at risk is difficult to justify.”

The Fed’s shift on employment

The biggest shift from the Federal Reserve coming out of Jackson Hole was on the employment side. Granted, much of the discussion leading to the anticipated changes focused on inflation.

Unlike many other global central banks, the Federal Reserve’s dual mandate of price stability and maximum employment lends to flexibility. And we are not suggesting the framework changes were intended this way, but when reading through notes from the Fed Listens, moving forward with coronavirus, the primary concern on both the fiscal and monetary side should be jobs.

What changed specifically with the Fed’s mandate on employment?

The Fed is wagering that very loose financial conditions over time will foster a very tight and strong job market, without concerns of inflation. With this, ambition that an inclusive mindset of employment across all demographics, leaving no one behind, will be full employment.

A review of last week’s meeting: where is the Fed’s head at going into the election?

One key phrase from the Fed’s statement at the September meeting:

“The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time”

Following the meeting, many are calling this sentence from the Fed’s statement as outcome based forward guidance. Certainly, there is guidance within this sentence, yet the wording is vague and leaves questions.  

• “Assessment” of maximum employment. The Fed wants unemployment back toward 3.5%.
• What defines “on track” relative to an inflation overshoot?
• Moderate, for some time, means what?

Summary of Economic Projections (SEP)

The Summary of Economic Projections (SEP) puts the Fed on hold at least through 2023 with upgrades to employment, growth and inflation. In the end for 2023, the committee’s median assessment of unemployment and inflation are 4% and 2% respectively with a funds rate at zero. The SEP did not, however, explicitly show inflation overshoots within that period. Lends itself to a vague box called “longer run” which clearly would take us out through 2025.

Large Scale Asset Purchases (LSAP)

This is about accommodation, not just stabilization. Chairman Powell has said this before: the monthly purchases of both Treasuries and mortgages is lending to market accommodation and rate levels. We feel so long as rates further out the curve move higher with improving economic conditions, within reason the Fed will be tolerant of slightly higher rates so long as financial conditions overall remain on the looser side. Tightening financial conditions will garner the Fed’s attention.

Forward guidance

Chairman Powell was vague on maximum employment:

“Maximum employment is not something that can be reduced to a number the way inflation can. We’re not looking at a rule, we’re looking at a judgmental assessment, which we’ll be very transparent about as we go forward.”

The Fed’s official language change from Jackson Hole on maximum employment:

“The maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time largely to nonmonetary factors that affect the structure and dynamics of the labor market. Consequently, it would not be appropriate to specify a fixed goal for employment: rather the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level recognizing that such assessments are necessarily uncertain and subject to revision.”

Inflation

Moderately above. Moderate is moderate according to Chairman Powell, for “some time.” This does not mean months. Here’s the bottom line: when questioned about the SEP and lack of overshoot in the assessment, Powell was vague in his response that it is going to take a long time. Based on the SEP projections, longer than 2023.

Bullets left

Chairman Powell: Can adjust asset purchase sizes and the mix in terms of duration and securities. This is certainly not a new thought but reiterated. The Fed has always said: they are prepared to do more if needed.

Fiscal

The push back continues, which is a theme of ours. The Main Street Lending facility has hardly been touched and Chairman Powell acknowledged the Fed’s lending powers under section 13(3) which were amended to be more stringent through Dodd-Frank. In the end, the Fed can only lend to solvent companies.

Inequality

The Fed looks very closely at employment across all demographics. With that said, Chairman Powell was honest that the Fed has one rate and that its application is largely up to elected officials. Little doubt the fed will be very sensitive to inclusiveness as we work though the pandemic.

Financial instability

Chairman Powell: “Not as tightly related to monetary policy as one would think.”

We have discussed Powell’s view on this coming out of his NPR interview before the blackout period heading into September’s meeting. The Fed views the first line of defense for financial stability to be regulatory, stress tests, etc. While this is backward looking, it’s also real.

A vaccine

Certain segments of the economy will continue to struggle without a vaccine. Yet, in many other aspects we are learning to live with the virus and adjusting with masks and social distancing. As expected, the Fed continued to link the evolution of the economy to the virus in their statement last week.  

Job market

The Fed wants it back to early 2020. Chairman Powell said “absolutely” when questioned last week. Is there any formal guidance needed?

The Fed wants a strong job market, broad based and inclusive, with wages rising. Their bet is that they will get it without inflation rearing its head and thwarting the mission.

Conclusion

There were no big surprises from the Fed last week. To date, they have been very clear with informal guidance; more tolerant with inflation, wanting the job market back to earlier in 2020 (3.5% unemployment rate). With no guidance on further balance sheet expansion, we have moved sideways short-term in markets.

NASDAQ, the USD, Gold, 10-year yields and the Fed Balance Sheet

The Fed is playing the long game here, wagering that inflation will not be an issue, as they let the job market heal throughout the pandemic. This is very similar to the period from late 2018 through the 2019 pivot; we do not believe the Fed will be shy about leaning on different sides of their mandate along the way. Unwanted inflation is the Fed’s biggest risk by far.

Chairman Powell was clear last week, when he stated that both sides of the mandate need to be fulfilled. Last week’s statement from the Fed lends itself to a great deal of commitment, yet at the same time monetary discretion along the way.

In outlining the past couple of years, including the pandemic, the yield curve stands out as too pessimistic. The Fed can always adjust asset purchases to emphasize longer dated duration – yet, they are showing restraint. The market should be open-minded and prepared for a steeper curve as the economy continues to rebound, as we move through the 2020 election, into better days in 2021.