April 21st, 2016 | By Nick Sargen
One of the main lessons I’ve learned over my career is that it is wise to heed the Wall Street dictum about not fighting the Fed. This was particularly important during and after the 2008 financial crisis, when Ben Bernanke pursued unorthodox policies such as quantitative easing (QE) to bolster the economy and financial system.
While many observers at the time questioned these policies and some believed they would be inflationary, my assessment was the initial response would reassure investors about the soundness of the U.S. financial system, and we added to positions in risk assets.
Thereafter, as the Fed engaged in successive rounds of QE, I questioned whether the benefits to the economy would outweigh the costs in terms of distortions in the pricing of financial assets.
Today, it is evident that the Fed is having a difficult time pursuing its “exit strategy.” One reason is that investors became addicted to a steady diet of QE. This was particularly evident in mid-2013, when Bernanke signaled the Fed would begin to wind down its QE program, and Treasury yields spiked by 130 basis points. Fed officials were caught off guard by this development, and they did not complete the wind-down until the fourth quarter of 2014.
Another reason is that the Fed is finding it increasingly needs to take international considerations into account in fulfilling its dual mandate of full employment and low inflation. On several occasions over the past year – the September-October FOMC meetings and those in the first quarter of this year – the Fed backed away from tightening policy amid concerns about the global economy and plummeting oil prices, which triggered a steep sell-off in risk assets while U.S. treasuries rallied.
According to Yellen, this mechanism in which the bond market responds to weak global conditions is an important “automatic stabilizer” for the economy. However, the Fed’s behavior also suggests that its own reaction function to market developments may have changed, as it recognizes the powerful effect market forces can have on the global economy.
In short, the world today is very different from the past, when the Fed could set policy independent of developments abroad. Previously, the adage “when the U.S. sneezes, the world catches a cold” was an apt description of how it acted. Today, by comparison, some have argued that while the United States can create spill-over effects for the rest of world, there are also “spill-back” effects of developments abroad on the U.S. economy and financial markets that the Fed must take into account.
The latter is particularly evident in the foreign exchange markets. Over the past year actions by the European Central Bank and the Bank of Japan to pursue negative interest rates caused the dollar to strengthen considerably, which hurt U.S. exports and earnings of multinationals. The dollar’s appreciation, thus, was equivalent to a tightening in financial conditions. However, when the Fed signaled to market participants that it would proceed more slowly in raising interest rates, the dollar subsequently weakened against the euro and the yen while commodity prices firmed.
Ultimately, in making decisions about the likely course of U.S. interest rates, investors must decide whether they concur with the views of FOMC participants about the future course of rates or with the path of rates that are embedded in the bond market.
For the past few years, at least, investors would have come out ahead if they positioned based on market forecasts rather than the Fed’s internal projections, which proved to be too optimistic. This was also the case at the beginning of this year, when the Fed’s economic forecast called for real GDP growth to be 2.4% in 2016, and the consensus view of FOMC participants was the fed funds rate would be raised by 100 basis points, or four times this year. By comparison, bond investors at the time envisioned the funds rate would be increased only two times this year. Currently, in the wake of concerns about the global economy, both sets of forecasts have been revised downward, with the FOMC now expecting to move twice this year, while bond investors have ruled out any rate increases.
Our own view is that the path of interest rates over the next few years is likely to be somewhere between these views. Thus, while the tendency of the Federal Reserve has been to be overly optimistic about the economy, bond market participants have proved to be fickle, at times pricing in a fairly high prospect of recession while at other times clinging to a more sanguine view. In our view, bond market participants appear overly pessimistic now.
My own take is that the U.S. economy has grown at a trend of 2%-2.25% since the expansion began in mid-2009, and it is likely to sustain this pace for the next couple of years. If so, it would suggest the unemployment rate will continue to fall and eventually reach 4.5% or lower. Over time, as wage pressures begin to build, the core inflation rate is likely to reach the Fed’s 2% threshold.
Normally, such a pattern would imply a federal funds rate of at least 3.0% as a long-term equilibrium, which is what FOMC participants have forecast by the end of 2018. The main risk to this outlook is developments outside the United States that could increase uncertainty about the economy’s prospects. Thus, if the global economy were to stay weak, the future path of interest rates is likely to be below the one projected by FOMC participants.
In my view, however, the current forecast embedded in the bond market of a funds rate below 1% by the end of 2018 is too low. The reason: It would imply little or no economic growth and inflation over the next three years. While this outcome cannot be ruled out, it is not the most likely outcome.