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This guest commentary was written by Mike O'Rourke of JonesTrading. This piece was originally published on 7/12.

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Once again, the equity market provided the most recent illustration that Federal Reserve policy has broken the market mechanism as the S&P 500 rallied sharply in reaction to Chair Yellen’s prepared testimony to Congress. The testimony offered no new policy insight, yet the market celebrated a view the Chair has repeatedly reiterated for more than two years. 

The following is the key line in the testimony that excited the equity market:

Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.”  Yellen defines a neutral policy stance “as the level of the federal funds rate that would be neither expansionary nor contractionary if the economy was operating near potential.” 

Thus, the reasons policy is close to the neutral stance are twofold. 

First, the potential GDP growth is significantly weaker than historic averages. Think in terms of secular stagnation and San Francisco Fed President Williams saying he believes potential GDP is 1.5% a couple of weeks ago.  Second, the rate of inflation dropped approximately 40 basis points over the past 3 months, lowering the target for the neutral policy rate.

What Is Yellen Talking About? "Neutral Policy Stance"

When Chair Yellen talks about the “neutral policy stance,” she is referring to the level of the Real Fed Funds Rate that is “neither expansionary nor contractionary.”  This is always a moving target, especially because of the inflation gyrations that occur.  In measuring the Real Fed Funds Rate, Chair Yellen takes the Fed Funds Rate and subtracts the rate of inflation as measured by the annual percent change of the Core PCE Price Index.  In the 5 years prior to the Great Recession, the Real Fed Funds Rate averaged 1.16%.  In the decade prior to the Great Recession, the Real Fed Funds Rate averaged 2% (chart below).

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Reading Between the Lines: What Yellen Actually Means...

You could consider those levels the “neutral policy stance” for their respective time frames.  What Yellen is saying today, and has been saying since 2015, is that the post crisis potential GDP for the US economy will not allow the Real Fed Funds Rate to return to 1.16% or 2% without significantly choking off growth.  Instead, Chair Yellen has repeatedly reiterated her belief that the new appropriate Real Fed Funds Rate for this current state of the economy is zero percent. 

Since a Real Fed Funds Rate of zero percent is Chair Yellen’s near term target for a “neutral policy stance,” that means the “Nominal (actual) Fed Funds Rate” short term target is equal to the rate of inflation (chart below).  Over the past 3 months, Core PCE has dropped 38.5 basis points.  Thus, the decline in inflation brings the Real Fed Funds Rate closer to the “neutral policy stance,” eliminating the need for 38.5 basis points of additional hike for the time being.  “Real” policy in terms of the neutral stance is the tightest it has been since September 2008.  

These are not new developments.  In May, when April PCE exhibited the inflation decline, we noted that:

The April PCE Deflator was released today and the year over year change for the Fed’s inflation indicator was 1.7%, the slowest pace of 2017.  As inflation drifts lower from its target, it also means the Fed Funds rate is closer to that unofficial near term neutral level...”  Late last month, we further noted that “Going forward, when thinking about tight or easy monetary policy, we should remember that Chair Yellen believes the “neutral Fed Funds Rate” for the current environment is zero percent.  That means when the real Fed Funds Rate rises to zero, the Fed Funds Rate will no longer be providing excess accommodation for the current state of the economy…  In theory, for the current state of the economy, the FOMC is two rate hikes away from the appropriate level of the Fed Funds Rate.” 

Below are a few of the many examples going back more than 2 years when Chair Yellen has asserted that a zero percent Real Fed Funds Rate is a “neutral policy stance.”  In short, what Yellen stated today reiterated what she has been saying for some time.  What the market needs to realize is that Core PCE is theoretically the independent variable driving where that neutral policy rate is and how many additional Fed Funds Rate hikes will get us there. Since we receive a new inflation reading every month, this will remain a moving target.  

As far as the market reaction is concerned, we are confident that computer models and passives don’t read the Fed Chair’s statements.  Since this is an environment where “price sets the narrative,” the spin will be that Chair Yellen was dovish as rates continue to rise (especially the real rate) and the balance sheet normalization process commences. 

The Neutral Policy Stance

March 27, 2015

"At present, the equilibrium real federal funds rate, which by some estimates is currently close to zero, appears to be well below the longer-run normal levels assessed by the FOMC."

March 29, 2016

"Although estimates vary both quantitatively and conceptually, the evidence on balance indicates that the economy’s “neutral” real rate--that is, the level of the real federal funds rate that would be neither expansionary nor contractionary if the economy was operating near its potential--is likely now close to zero."

June 6, 2016

"First, the current stance of monetary policy is stimulative, although perhaps not as stimulative as might appear at first glance. One useful measure of the stance of policy is the deviation of the federal funds rate from a “neutral” value, defined as the level of the federal funds rate that would be neither expansionary nor contractionary if the economy was operating near potential. This neutral rate changes over time, and, at any given date, it depends on a constellation of underlying forces affecting the economy. At present, many estimates show the neutral rate to be quite low by historical standards--indeed, close to zero when measured in real, or inflation-adjusted, terms."

March 3, 2017

"It is difficult to say just how low the current neutral rate is because assessments of the effect of post-recession headwinds on the current level of the neutral real rate are subject to a great deal of uncertainty. Some recent estimates of the current value of the neutral real federal funds rate stand close to zero percent."

EDITOR'S NOTE

This is a Hedgeye Guest Contributor research note written by Michael O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.

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