Reality vs. The Neutral Rate

Doug Nolan

How about a cursory look at recent economic data: February’s 57.7 ISM Manufacturing reading was the strongest since August 2014. New Orders at 65.1 matched the strongest level (Dec. 2013) since 2009. Prices Paid at 68 was only slightly below January’s 69, the strongest since 2011. February’s ISM Non-Manufacturing Index rose to 57.6, the highest since October 2015 (58.1). Auto sales in February were just below record levels. Last week’s Initial jobless claims (223,000) were the lowest since March 1973. Weekly mortgage purchase applications bounced back to near seven-year highs. Trade deficits are running at the widest level since before the crisis.

The PCE (Personal Consumption Expenditure) Deflator was up 0.4% in January, increasing y-o-y gains to 1.9%. This matched the highest y-o-y reading in almost five years. Core PCE was up 0.3% for the month, pushing y-o-y gains to 1.7%.

The Conference Board’s February Consumer Confidence reading rose to the highest level since July 2001. At 133.4, the Conference Board Present Situation index jumped to the high since July 2007 - and is now only five points away from a 15-year high. Personal Income added 0.4% in January, increasing y-o-y income growth to 4.0%.

After incredible 2016 inflows of $305 billion, Vanguard has attracted flows of $80 billion in just the first two months of the year.

March 3 – Wall Street Journal (Asjylyn Loder): “Investors poured $62.9 billion into exchange-traded funds in February, pushing the year-to-date world-wide tally to $124 billion, the fastest start of any year in the history of the ETF industry, according to… BlackRock Inc. U.S. ETFs accounted for $44 billion of that, pushing assets in U.S. funds to almost $2.8 trillion. Most of the money went to cheap, index-tracking ETFs…”

February 28 – Bloomberg (Sid Verma and Oliver Renick): “You can thank the little guy for Dow 20,000. That’s the takeaway from data tracking money flows into and out of stocks, according to… JPMorgan… The telltale sign retail investors are behind the longest string of U.S. stock highs in decades? An $83 billion surge of cash into passive strategies so far this year amid a $15 billion withdrawal from actively managed funds. That’s on top of evidence that institutional traders have backed away, the bank says.”

March 3 – Bloomberg (George Caliendo and Michael Hyler): “U.S. investment grade corporate bond sales totaled more than $281 billion in the first two months of the year, the most in at least 10 years. Exxon Mobil Corp is among the companies that could keep issuance at a record pace in the first quarter of 2017.”

They’ve really gone and done it this time. The Fed had cut rates from 8.25% in 1990 to a cycle low 3.0% in September 1992. Ignoring a policy-induced speculative bubble inflating throughout the bond and mortgage derivatives markets, the Greenspan Fed waited to begin normalizing rates until February 1994. In 2001, Fed funds began the year at 6.50% and were then slashed to only 1.00% by June 2003. The Fed didn’t take its first baby-step increase until June 2004, after several years of double-digit mortgage Credit growth and a mortgage finance Bubble that had gathered powerful momentum.

The current remarkable cycle has brought new meaning to the phrase “Behind the Curve.” 

Rates were cut from 5.25% starting back in September 2007. By December 2008 they had been slashed to zero (to 25bps), with the DJIA ending the year at 8,876. Now, with the DJIA at 21,000, Fed funds sit today at only 0.75%. Rates have budged little off zero despite record securities prices, record corporate bond issuance, record home prices and a 4.8% unemployment rate.

While Q4 data will be out soon, it appears that 2016 posted the largest Credit growth since 2007. Through the first three quarters of 2016, non-financial Credit expanded at an annualized pace of just under $2.4 TN, not far off 2007’s record $2.503 TN. For comparison, non-financial debt expanded $1.259 TN in ‘09, $1.589 TN in ‘10, $1.309 TN in ‘11, $1.916 TN in ‘12, $1.545 TN in ‘13, $1.807 TN in ’14 and $1.931 TN in ‘15.

The strongest Credit expansion in years is led by robust growth in consumer Credit, corporate debt and federal borrowings. Even mortgage Credit has picked up to the fastest pace since 2007, after years in the doldrums. In my parlance, years of accelerating Credit expansion have engendered self-reinforcing inflationary biases throughout the economy, most notably in securities, real estate and asset prices more generally. Increasingly, however, rising incomes have begun fueling some inflationary pressure even in the traditional consumer price arena.

U.S. Credit growth and economic activity had attained sufficient self-sustaining momentum by 2014 and 2015 for the Fed to have launched so-called “normalization.” It was a major policy blunder not to have this process well underway by 2016. The Fed basically disregarded domestic considerations as it postponed rate adjustments after the single December 2015 baby-step.

The faltering Chinese Bubble from a year ago held sway, not only with respect to Fed policy but for the ECB and BOJ as well. A Chinese bust clearly had major ramifications for the global inflationary backdrop. Yet there’s always that thin line between a bursting Bubble and the acquiescence of irrepressible “Terminal Phase” excess. As it turned out, rather than a disinflationary shock catalyst for a susceptible world, China’s aggressive reflationary measures ensured record 2016 Credit expansion and attendant upside inflationary pressures at home and abroad. China historic Credit Bubble is ongoing, and it’s pulling global inflationary dynamics along for the ride.

From the conclusion of Yellen’s Friday Afternoon speech – “From Adding Accommodation to Scaling It Back:” “We [support continued growth… in pursuit of our… mandates], as I have noted, with an eye always on the risks. To that end, we realize that waiting too long to scale back some of our support could potentially require us to raise rates rapidly sometime down the road, which in turn could risk disrupting financial markets and pushing the economy into recession. Having said that, I currently see no evidence that the Federal Reserve has fallen behind the curve, and I therefore continue to have confidence in our judgment that a gradual removal of accommodation is likely to be appropriate.”

Of course chair Yellen is not about to conceded that the Fed has fallen “Behind the Curve.” Her speech, however, was heavy on rationalizing and justifying why the FOMC has been incredibly reluctant to begin normalizing policy.

Gauging the current stance of monetary policy requires arriving at a judgment of what would constitute a neutral policy stance at a given time. A useful concept in this regard is the neutral ‘real’ federal funds rate, defined as the level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a ‘neutral’ policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator…”

In the Committee's most recent projections last December, most FOMC participants assessed the longer-run value of the neutral real federal funds rate to be in the vicinity of 1%...”

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...”

In 2015, the unemployment rate fell significantly faster than we generally had anticipated in 2014. However, a series of unanticipated global developments beginning in the second half of 2014--including a prolonged decline in oil prices, a sizable appreciation of the dollar, and financial market turbulence emanating from abroad--ended up having adverse implications for the outlook for inflation and economic activity in the United States, prompting the FOMC to remove monetary policy accommodation at a slower pace than we had anticipated in mid-2014…”

Future historians will be unimpressed with the Fed’s whole line of “neutral rate” analysis. It’s certainly reminiscent of chairman Greenspan’s late-nineties foray into the New Economy’s “faster speed limit” -- as rationalization for evading the tough action necessary to rein in excessively loose monetary conditions and resulting speculative asset markets. Yellen presented a reasonably comprehensive analysis of Fed thinking, yet her Friday speech does not include the either the word “Credit” or “money.” Regrettably, it’s the same flawed theoretical framework that has gotten the Fed – and the rest of us - in repeated trouble for the past three decades.

Ten-year bond yields were 5.6% when the Fed moved to tighten policy in February 1994. Yields then shot all the way to 8.0% into early November. The Fed took from that experience the notion that it must clearly signal to the markets that rate increases will be gradual and quite measured. This fundamentally altered how the bond market responds to Fed policy changes. 

Indeed, a case can be made that since ’94 the Fed has avoided measures that would actually tighten financial conditions. Ten-year yields were at 4.7% when the Fed initiated tightening measures (at 1.25%) in May 2004, before ending the year at 4.2%. Fed funds were up to 5.25% by June ’06, though 10-year bond yields had increased to just over 5%. Bond yields then began 2007 at 4.7%, market rates sufficiently low to ensure quite loose financial conditions and prolong the dangerous Bubble.

Ten-year yields closed Friday trading at 2.48%. Clearly, the bond market has little fear of Fed tightening measures. At this point, the backdrop is showing similarities to the 2004-2007 Bubble period where Fed rate increases couldn’t keep up with rising inflationary biases – in securities and asset prices, as well as throughout the real economy.

The Fed’s focus on some abstract “neutral rate” is foolhardy central banking, especially when it comes at the expense of analysis of Credit and monetary factors. For a central bank supposedly “data dependent”, how are the markets to gauge and interpret such a nebulous theoretical concept (other than as rationalization for disregarding asset inflation and bubbles)?

What was the “neutral rate” one year ago, with China in trouble, global markets faltering, crude at about $40 and CPI measures pointing downward? How about today, with record global Credit growth, booming markets, crude at $53 and CPI trends pointing almost straight up? The ISM Prices Paid index was 33.5 in January 2016 – the low since 2009. By January 2017 it had more than doubled to 69, the highest in almost six years. “Neutral rate” has no practical policy relevance in a period of such monetary and price disorder.

The Fed surely hopes to offload some of their tightening work to the financial markets. So far, ebullient markets seem rather determined to sustain ultra-loose financial conditions. If inflationary forces have finally gathered self-reinforcing momentum, dillydallying several years to get Fed funds up to three or four percent is not going to cut it. It seems obvious that the Fed has fallen way Behind the Curve. And this may be irrelevant to markets currently, though this phase will pass. It’s sure disconcerting to see the public throw “money” at equity index products at this stage of the market cycle. The Fed has cultivated the misperception that it’s a whole lot safer than buying Bubble technology stocks in 1999 or Bubble equities and houses in 2007.

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