What caused the Fed’s dovish turn?

Gavyn Davies

Several commentators (see here, here and here) have noted recently that the Federal Reserve has made a major shift in its attitude towards the future path for US interest rates. When the FOMC increased rates last December, they seemed quite confident that the 0.25 per cent hike was the first in a long line of similar increases each quarter, driven by the need to “normalise” interest rates gradually over time.

At that stage, they also seemed fairly sure that they knew what “normal” meant. Now, they seem to have lost that certainty, and have simultaneously shifted their central assessment of the “normal” level for short rates sharply downwards. This has not surprised the markets, which moved in that direction well ahead of the FOMC. But it has strengthened the conviction among investors that the doves are now firmly in control at the Fed.

Last week, Ben Bernanke released an important blog, analysing the main reasons for the FOMC’s change of view, and largely giving his seal of approval. Although the former Fed President has of course been inclined towards dovishness ever since 2008, it is significant that he views the shift as being underpinned by deep fundamental forces inside the US economy, not by minor fluctuations in incoming economic data.

Mr Bernanke is certainly right that domestic fundamentals have changed, but I think his blog has underplayed another significant reason for the Fed’s shift, which is a dawning realisation that events in foreign economies are far more important in determining the equilibrium level of US rates than has previously been accepted. In fact, this has probably been the main factor in the Fed’s U-turn this year.

Until this changes, the Fed will err on the dovish side whenever a key decision is taken.

The Bernanke blog attributes the dovish shift to three main factors: a drop in the FOMC’s estimate of the long run economic growth rate (y*); a fall in its estimate of the natural rate of unemployment (u*); and a very large drop in its estimate of the neutral or “natural” rate of interest (r*) [1].

It is clear that each of these factors could reduce the Fed’s expected path for actual short rates in the next few years. Not only is the final destination for rates (r*) reduced, but the urgency in getting there is also lessened. This thinking is likely to be reflected in Janet Yellen’s speech at Jackson Hole on 26 August.

Of the three Bernanke factors, the most important is undoubtedly the drop in the median estimate of r* made by the FOMC’s participants. The slightly odd feature of this change is that it seems to have happened long after the financial markets came to the view that r* had declined.

In the graph, we compare the real equilibrium interest rate that appears in the Fed’s projections with that built into the yield curve for US treasuries. Note that these are not the same rates, because the Fed only publishes its “long term” forecast for the Fed Funds rate, while the market rate chosen is the 5 year real rate, 5 years forward [2].

Nevertheless, the difference is stark. The market seems to have given considerable credence to the likely permanence of ultra low US interest rates ever since 2011. Meanwhile the FOMC has very belatedly adjusted its view downwards towards that of the market, accelerating the speed of its downward adjustment only after the middle of 2015.

What has caused the sudden drop in the Fed’s estimate of r* since mid 2015, and particularly in the first half of this year? Interestingly, this has not occurred because the Fed has been surprised by the behaviour of the economy since then. The FOMC’s median forecasts for both GDP growth and core inflation have barely changed over this period:

Of course, it is possible that the FOMC has reacted to earlier evidence of slowing productivity growth and a falling u* only with a very long lag, which would be embarrassing if true. But it is also possible that something else came along to change the FOMC’s estimate of r*. And that something must surely have been the impact of international factors, including the dollar, on Fed thinking this year.

If we look closely at the timing of the change in the Fed’s guidance about “normalisation” of rates, it came predominantly around the time that the dollar peaked (and equities collapsed) in February/March this year. This did not lead to any change in the Fed’s estimates of either GDP growth or inflation, but it did lead to a change in their expected mix between the exchange rate and domestic interest rates in delivering the tightening in financial conditions that they desired at the time. A higher dollar essentially forced them to accept lower interest rates in order to deliver roughly the same path for overall financial conditions in the economy.

Furthermore, this was not expected to be just a temporary shift in the mix. The drop in r* indicates that it is expected to be long lasting. Why is this?

The best analysis of this issue from inside the Fed has come from Lael Brainard, a relatively new member of the Board of Governors with a particularly strong international orientation in her thinking. To her credit, she pointed to all of these international factors before the FOMC raised rates last December (though she then went along with the change).

In her latest speech in June, she again emphasised the importance of global deflation risks, especially in China. These risks will lead to a very long period of aggressively easy monetary policy outside the US, which in turn will make the dollar far more sensitive to US rate hikes than has been the case in some earlier periods. The Fed should not, she argues, ignore this when setting US rates: the equilibrium interest rate in America has been reduced by events overseas.

This analysis lies outside the Fed’s normal comfort zone, and contradicts the standard analysis produced by Stanley Fischer among others last year. It was overlooked entirely by Ben Bernanke last week. But it does seem to have determined the behaviour of the FOMC for much of this year.



[1] Mr Bernanke also draws attention to recent work by James Bullard which suggests that the Fed should not alter interest rates until the economic “regime” changes. This is an important theoretical development, but it does not seem to have gone mainstream on the FOMC yet.

[2] The 5-year real bond yield in the TIPs market, 5 years forward, is often used by investors as a guide to the market’s view of the natural long run rate of interest. If the term premium is positive, as is usually assumed, then the difference between the Fed’s and the market’s implied estimate of the natural long run rate of interest is larger than shown in the graph.

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