The guest commentary below was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
President Donald Trump caused a bit of a stir last week when he suggested that rising interest rates are cause for concern. Pundits fretted about “Fed independence,” a concept rendered completely meaningless in the age of quantitative easing. We agree with the President that Federal Reserve Board Chairman Jerome Powell is “a good man,” yet we also think it is high time that elected officials started to hold the Federal Open Market Committee more accountable for its policy decisions.
Powell nicely describes the concept of accountability. “We owe you and the public in general clear explanations about what we are doing and why we are doing it,” said the Fed Chairman to the Senate Banking Committee last week. “Monetary policy affects everyone and should be a mystery to no one.” With the yield curve also last week nearing a zero difference between short and long-term government debt, Powell’s comments are timely.
In an exchange with Senator Bob Menendez (D-NJ), Powell essentially endorsed QE2 and Operation Twist, saying that he was “glad” that the FOMC continued to manipulate the bond market years longer than necessary in the quest for the holy grail of full employment.
Agreeing with the position taken by Treasury Secretary Steven Mnuchin, Powell also endorsed the privatization of the GSEs. He told Senator Jon Tester (D-MT) that it was important to get the housing finance system “off of the federal government’s balance sheet” to foster long term economic growth. In the subsequent exchange with Senator Pat Toomey (D-PA) at ~ 2:05, Powell deflected a fairly pointed question about the Fed’s “deliberate” manipulation of the Treasury yield curve.
“Historically, the Fed has just manipulated short-term rates, the discount rate and the fed funds rate, and let the markets decide other interest rates” said Senator Toomey. “That all changed with quantitative easing when the Fed became the biggest market participant in with respect to the purchase of Treasuries and it changed in an explicit way when the Fed decided that it would intentionally manipulate the shape of the yield curve with Operation Twist, which was very consciously and willfully designed to change the shape of the curve.”
“Some people are concerned that a flattening curve or an inverted curve correlates with economic recession,” Toomey continued in a remarkably cogent question. When he asked Powell about whether the changing shape of the curve would alter Fed policy regarding the composition of the balance sheet, Chairman Powell responded:
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“What really matters is what the neutral rate of interest is. I think people look at the shape of the curve because they think there is a message in longer run rates, which reflect many things, but that longer rates tell us something about the longer run neutral rate. That is really why the slope of the yield curve matters. So I look directly at that. If you raise short-term rates higher than long-term rates, then maybe your policy is tighter than you think.” |
Powell may not be an economist by training, but he is sure starting to sound like one – to our great concern. Conceptually, the neutral (or natural) rate of interest (R* in economist lingo) is the rate at which real GDP is growing at its trend rate, and inflation is stable. This decidedly indefinite concept is widely attributed to Swedish economist Knut Wicksell and, it is alleged, “forms an important part of the Austrian theory of the business cycle.”
In 2006, Joachim Fels and Manoj Pradhan put forward the case for using neutral interest rates in formulating monetary policy in the Financial Times:
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“Put simply, the natural rate of interest is the interest rate that keeps output at its potential and inflation stable, once any shocks to the economy have played out. Wicksell saw fluctuations of the interest rate set by the central bank around the natural rate as the main driver of the business cycle and swings in the price level. His work foreshadowed and influenced the Austrian monetary business cycle theorists in the early part of the last century, most notably Ludwig von Mises and Friedrich von Hayek.” |
Most adherents to free market economic ideas agree with the 20th Century American economist Irving Fisher (1867-1947) in rejecting the idea of a discernable “business cycle” along with speculations about natural or neutral interest rates. Concepts like neutral interest rates, equilibrium and full employment are, by definition, indefinite and speculative, much like calculating the position of an object moving through space-time, to borrow from the work of Stephen William Hawking (1942 - 2018).
Irving Fisher put the issue nicely in his 1933 essay on debt deflation when he refuted the existence of business cycles:
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“The old and apparently still persistent notion of "the" business cycle, as a single, simple, self-generating cycle (analogous to that of a pendulum swinging under influence of the single force of gravity) and as actually realized historically in regularly recurring crises, is a myth. Instead of one force there are many forces. Specifically, instead of one cycle, there are many co-existing cycles, constantly aggravating or neutralizing each other, as well as co-existing with many non-cyclical forces. In other words, while a cycle, conceived as a fact, or historical event, is non-existent, there are always innumerable cycles, long and short, big and little, conceived as tendencies (as well as numerous noncyclical tendencies), any historical event being the resultant of all the tendencies then at work. Any one cycle, however perfect and like a sine curve it may tend to be, is sure to be interfered with by other tendencies.” |
Unlike market interest rates, the neutral rate or R* is the product of a model. The whole notion of “neutral” market rates goes hand in hand with neo-Keynesian concepts such as market equilibrium and full employment. Neither can be observed or even described scientifically, much less replicated via experimentation. This fact did not prevent Chairman Powell from telling Senator Toomey that he “looks at it” – namely the invisible and indiscernible natural rate of interest -- when assessing US monetary policy.
Sadly, Senator Toomey ran out of time and was not able to follow-up with Chairman Powell on the rapidly flattening yield curve. One question he ought to ask is why the FOMC thinks that “deliberately” manipulating the prices of and yield spreads between different securities is OK but that the Committee is now justified in doing nothing to manage the process of normalization as the curve very deliberately inverts.
Powell’s view of the neutral interest rate apparently includes doing nothing to raise long-term yields while we see a steady runoff of the System portfolio and an attendant decrease in excess reserves and, of necessity, bank deposits. A flat yield curve is apparently not a concern for the FOMC, parsing Powell’s comments, because the neutral interest rate is above current market rates. But nobody reall knows. As Tao Wu of the San Francisco Fed noted in 2005: "The difficulty policymakers face is that it is not obvious exactly what the level of the neutral real rate is. It cannot be observed directly. There is no reliable way to estimate it. And it can change."
Of course, in order to assess the “neutral” rate of interest, you need to have an accurate idea about the current level of inflation. As we’ve noted in past comments, key measures of inflation such as the PCE deflator seem to be distorted to the upside because of noise coming from, of all things, financial services. Strangely, nobody at the Fed seems to be worried that a key benchmark for describing inflation may be overstated – and this may be due to the financialization of the US economy described so eloquently by Senator Toomey last week.
Our friend Brian Barnier of FedDashboard reports from a distant airport that he’s continuing to poke around to understand the weird behavior of financial services in the PCE deflator. “I am still tearing apart the time series,” he reports. “At the moment it seems the distortion comes from a combination of excess reserves and not accounting for how banks have become more digital. Will see what it looks like after they send me more specifics.”
Chairman Powell and other FOMC members may think they know where the neutral interest rate is at present, but we’d like to see our esteemed Fed chief be a tad more specific about this key policy metric. Of note, in an April 2018 IMF working paper, "Estimates of Potential Output and the Neutral Rate for the U.S. Economy," the authors state that: “Estimates of potential output and the neutral short-term interest rate play important roles in policy making. However, such estimates are associated with significant uncertainty and subject to significant revisions.”
If Chairman Powell is wrong about the neutral rate, and continues to ignore the market message contained in a flattening yield curve, then the consequences for markets and investors could be quite serious. We notice, for example, that Morgan Stanley (MS) saw a 76% increase in interest expense in Q2 ’18 compared with a year ago. (See the most recent edition of The IRA Bank Book for our view of how a flat curve will impact US banks.)
At a minimum, the FOMC should consider engaging in open market intervention of the same magnitude as Operation Twist to manage the yield curve on the journey back to normal. As Powell stated last week, when short-term rates rise above long-term rates, then "maybe your policy is tighter than you think."
EDITOR'S NOTE
Christopher Whalen is Chairman of Whalen Global Advisors LLC. He has worked in politics, at the Federal Reserve Bank of New York and as an investment banker for more than 30 years. He is the author of three books Inflated (2010), Financial Stability (2014) and Ford Men (2017).
In 2017, he resumed publication of The Institutional Risk Analyst and contributes to many other publications and media outlets. He recently launched the first volume of The IRA Bank Book, a review of the operating and credit performance of the US banking industry written for institutional investors.
