The Fed Looks for Solutions In All the Wrong Places
Because of the way things have turned out, events that occurred ten years ago remain freshly relevant today in a way that couldn’t be said of past periods. The Crash of 1987, for example, was but a footnote in trivia by 1997. The oil embargo and nasty global recession of 1974-75 had by 1984 and 1985 become just a memory, though painful completely unrelated to the world of the mid-1980’s. In early 2007, by contrast, Ben Bernanke said subprime was contained and his fellow policymakers made other such statements that still haunt us today.
Before getting to those, we have to more completely appreciate why they still matter. There has been any number of examples particularly since last summer that can be applied in this context. The timing is itself important because the economy of the “rising dollar” that pushed the globe to the brink of recession (and it may have been, as revised benchmark estimates for accounts like US industrial production are still going lower) finally achieved what common sense alone could not. Central bankers finally got the message that QE didn’t work as it was supposed to.
That assessment, unfortunately, needs to be clarified and calibrated to the orthodox view. It’s not that QE failed, it just didn’t achieve any of its goals. In the real world, any such statement would be rightfully dismissed as nonsense. Economics, though, does not exist in the real world; it plays by rules of its own design.
Central bankers last summer became more and more attracted to the position that QE didn’t disappoint because the world did. By this view, which has to be so alluring to these economists hoping beyond hope to escape being blamed, balance sheet expansion is preserved as “stimulus.” It came up short simply because, they now think, it never had a chance. The global economy was so damaged that nothing would have made a difference.
How did the economy become that way? Such answers to such questions are not required, for economics doesn’t need to know what happened in order to make judgments about what happened. Earlier this week, Boston Fed President Eric Rosengren spoke at the 26th annual Hyman Minsky Conference at Bard College telling his audience that the Federal Reserve has changed without knowing why. No longer will monetary policy be conducted by interest rate “stimulus” alone, the central bank must now consider the circumstances of the 2010’s, circumstances that were never foreseen just ten years ago (or even two, for that matter).
Asset purchases like those through quantitative easing are here to stay, no longer specific to the emergency or extraordinary category. What was unthinkable in 2007 is now ordinary. The reason is the statistical view of economic decay, the so-called natural rate of interest, or R* (or R–star). By the best guesses of economists, R* has fallen so low that they will no longer be able to raise short-term rates very far. That means when the next downturn inevitably hits, monetary policy will be conducting “stimulus” from a much lower altitude far closer to the zero lower bound (ZLB) than they are comfortable with. By starting out so near zero, and nobody yet knows the eventual max rate the Fed might be able to achieve in this round, policymakers surmise that what were once non-standard policies will again (and again) be necessary to deliver what is still viewed as “stimulus” to punch through the ZLB.
How do they know what R* is or has been? Perhaps the pre-eminent scholar working on the modern interpretation of the natural rate is San Francisco Fed President (and CEO) John Williams. In a paper published the day after the FOMC voted for its second “rate hike”, Williams along with co-authors Kathryn Holston and Thomas Laubach wrote:
“Although economic theory provides insights into the various factors affecting the natural rate of interest, measurement of the natural rate of interest has proven more challenging. This arises because the natural rate, like other latent variables, must be inferred from the data rather than directly observed.”
In other words, they don’t really know. What they do know is that interest rates all around the world have fallen to extremely low levels, sometimes hugely negative levels, and therefore there must be “some” reason for it. Trying to reconcile how such massive “stimulus” failed to stimulate anything, they come up with a very low R* that, again, preserves monetary policy as “stimulus” while recognizing this reality where by public perception at the very least the world hasn’t turned out the way it was supposed to when subprime was contained.
In February this year, Williams wrote the following: “the U.S. economy has fully recovered from the recession following the financial crisis, and the most recent estimates of r-star there have shown no signs of rebounding.” The most obvious inference from that statement is that he is using the word “recovery” in a way that is very different from what it actually means. Recovery, as in the business cycle segment, means just that – complete healing from the trauma of recession. What Williams wrote instead was that the economy has fully recovered even though there is no sign of it having healed even slightly. He has detached monetary policy from reality because he thinks he can.
These statisticians, for that is all they are, start with all the same basic observations: low and uneven growth; low productivity; low interest rates; and then add one further assumption, that monetary policy in all its forms is stimulus. The combination of those four variables yields a low maybe even negative R*.
There are a great many possible faults with this thinking, of course. The part of the discussion that policymakers seem unwilling, because they are unable, to touch is the moment they calculate when R* landed in its current state. You will likely be unsurprised to find out that by all the best statistical inferences it is believed the natural rate fell to its pitiful state in late 2008. Sure, they try to distract from the blinding specificity of that calculation by constantly referring to how the value has been declining for many years, decades even, as if the massive financial and economic irregularity were just one event in a wider chain of possible causation.
By Williams’ own effort, his view of combined R* for four countries/currency jurisdictions, the US, Canada, the UK, and the euro area, averaged about 2.5% to 3% from 1986 to 2000, fluctuating downward from the early to mid-1990’s. Around the time the dot-com bubble burst, inferred R* declined to average about 2% during the housing bubble period. But it was during the Great “Recession” that it collapsed to less than 1% and has been declining still more ever since.
If we go back to those four variables I stated above, this time removing the final assumption, the world looks very different – and importantly much simpler. If we assume instead that monetary policy is not necessarily “stimulus” then we can very easily account for 2008 as well as what followed from it. The condition of persistently low and often negative interest rates has very little to do with R* (which is an offensive assumption all its own, for why would any complex economy, let alone in globally synchronized fashion, possess a single equilibrium interest rate, natural or not?). As his December 2016 paper is forced to admit, “there is substantial comovement in the estimates of the natural rates of interest and trend GDP growth across economies. This suggests an important role for so-called global factors influencing the natural rates.”
Germany’s 2-year federal Bundesschatzanweisungen currently “yield” about -0.81%. According to the R* view of them, they are that low due to all the bond buying of the ECB and the “stimulus” environment created by constant monetary policy effort. In early 2011, however, the 2-year paper was trading to yield almost 2% and didn’t catch its massive bid (price) until that July. By the time the ECB got around to the LTRO’s and other pocket change programs at the end of that year, market rates on the German 2s were already practically zero.
What’s really instructive about that history and the trading that has followed is that the yields on the Bundesschatzanweisungen are the very near perfect mirror image of eurodollar futures prices. While German bunds of all kinds, indeed all government debt, are indirectly related to monetary policy considerations, eurodollar futures are thought to be the most direct expression of them. By convention, eurodollar futures try to gauge what monetary policy will be like in the near and not-so-near future.
I wrote back in February:
“Prior to 2011 it was the greater possibility of normal, of overcoming liquidity preferences and not following Japan into a lost decade. After 2011, it has been instead the market giving up on the current decade, recognizing that it will be lost, as it has been, and working out what that might mean for the next one – just how lost will the second be, because it is by these prices all but certain. In the case of German federal yields, it might seem risk to the euro, but in reality it is the risk driven home by the eurodollar.”
Both German 2s as well as eurodollar futures (and US Treasury yields, even JGB’s to a degree) before summer 2011 priced in rising rates and the perception of them into the future that meant that markets expected all this monetary “stimulus” would work. Policymakers themselves expected no less, leaving R* as then a possible oddity rather than meaningful consideration even internally. Since July 2011, everything changed outside of brief “reflation” countertrends in late 2013 and again in late 2016. Over that time, both the Fed, ECB, and BoJ introduced and executed the largest “stimulus” program in human history, often in coordinated fashion.
The Fed and eurodollar futures over the last ten years have had a rocky relationship. It wasn’t just this past decade, though, as eurodollar futures trading in the pre-crisis, middle 2000’s was as much a “conundrum” as UST yields. There was surely a growing disconnect between them and the view of the world from monetary policy. According to central banks, they alone set policy rates and their expectations should form the bulk of trading considerations especially here. If the Fed says its policy rate will be 5.25% for the foreseeable future, as it was in early 2007, then who are eurodollar futures investors to speculate otherwise? You don’t ever fight the Fed.
At the FOMC meeting on May 9, 2007, the Committee was still digesting the first warnings that suddenly erupted earlier that year. In February, HSBC and New Century rocked the financial world and put the word “subprime” into the mainstream. The stock market suffered an anxiety-inducing mini-crash on February 27. By the time of the May FOMC meeting, things seemed to have calmed down, a more relaxed condition that many attributed to Bernanke’s infamous “subprime is contained” testimony to Congress in March 2007.
“MR. DUDLEY. The market turbulence that began in earnest on February 27 is now a distant memory. Risk appetites have recovered, volatility in the fixed income and equity markets has declined, and the U.S. equity market has climbed to a new high.”
One market that wasn’t behaving was eurodollar futures, an uncomfortable thorn in Dudley’s side as the then-Manager of the Open Market Desk. Though Dudley had pronounced the world back to normal, eurodollar futures were pricing a considerably different 2008, a shift that to the FOMC was palpably offensive since none of them saw any reason to change their monetary policy position at that time let alone one year hence.
To explain the nagging disparity, Mr. Dudley offered three possible explanations. The first was that futures prices do not reflect the “modal forecast”, merely the mean (think central bank fan charts). His third possible reason had to do with inflation expectations, meaning that some eurodollar investors were expecting further developing mortgage and housing difficulties which might actually aid the Fed in keeping down inflation. This was the ideal circumstance that the FOMC eventually adopted as its base case for the period.
Dudley’s second possibility is, in light of all that has happened over the span of now ten years and counting, the only real and still applicable explanation:
“MR. DUDLEY. Second, some investors may disagree with the FOMC about the outlook. In this case, they might anticipate that it will take time for the FOMC to come around to their way of thinking—leading to rate cuts that occur only later.”
They should have listened instead of dictated, for this market was correct in 2007 just as it was again in 2011.
There is one further clarification necessary to complete the historical accuracy. In thinking and increasingly believing this way, these markets (those like eurodollar futures, German 2s, etc.) were not forecasting as R* does that monetary policy was still effective if ultimately futile, but rather more and more realizing it wasn’t ever stimulus to begin with. In other words, the relentless march of eurodollar futures prices higher after 2011, and German 2s lower, was re-prioritizing probabilities to a world without recovery because monetary policy was indeed moneyless.
We know this because of both the 2011 crisis itself as well as the “reflations” after it. The FOMC danced around this very possibility in the depths of that episode, declaring unbelievable what was actually taking place. How could there have been another great, systemic, and global liquidity crisis after two QE’s and $1.6 trillion in bank reserves? From the August 9, 2011, FOMC meeting:
“MR. SACK. We are seeing a lot more discussion about the potential need for liquidity facilities. I mentioned in my briefing that the FX swap lines could be used, but we’ve seen discussions of TAF-type facilities in market write-ups. So the liquidity pressures are pretty substantial. And I think it’s worth pointing out that this is all happening with $1.6 trillion of reserves in the system.”
Does anyone really believe that markets didn’t notice the direct contradictory to established theory? It was, after all, an exact repeat of early 2007, where markets subjected to massive funding stress found out that central banks were unreliable masters of “currency elasticity” through either hubris or mechanics, either of which deficiencies could prove fatal. Under such circumstances, financial participants would surely yield to greatly higher liquidity preferences, preferring to hold more so the most liquid instruments at whatever cost or premium so as to be detached from relying on central banks to act in any future moment of need. Prudence demands at least that approach if not a great deal more.
The “rising dollar” was in many ways just the final proof, for it was both central bank disbelief as well as lack of operational capacity (particularly FX) that produced the negative global monetary climate of late 2014 lasting to the middle of 2016. In this world, R* has it all backward. Low interest rates are not registering effective “stimulus” that just can’t succeed, but instead the distinct absence of opportunity, the opposite side of liquidity preferences. If full recovery had been achieved as even a low R* suggests, then opportunity would have compelled someone, anyone, to supply the missing money (bank balance sheet capacity).
The only thing holding up the natural rate consensus, as that is what it has become, is the conjecture that QE was “stimulus” even though it didn’t work. Remove that assumption and R* dries up and floats away in the overwhelming sea of liquidity preferences, established in a way that even the economists of the FOMC in August 2011 (briefly) appreciated.
As I wrote at the outset, we are not yet done with 2007 because we can’t be. In many ways, the whole thing has been flipped upside down, or maybe just that convention has finally started comprehending things as they are instead of how they are “supposed” to be. We see it again just recently where eurodollar futures and interest rates are moving contrary to “rate hikes”, and what has been embarrassingly familiar the most recent trade dates back exactly to the last one. Alan Greenspan’s “conundrum” is reborn, but updated for what everyone except economists has learned.
Abraham Lincoln once said (or was it Mark Twain?) that it was better to remain silent and be thought a fool than to speak and remove all doubt. That is what the last decade has been for central banks; better to remain on the sidelines and be thought powerful than to act in considerable fashion and reveal otherwise. The big, important markets, those most closely attached to the real economy globally, suspected something was up ten years ago and then finally confirmed it in the summer of 2011. They have been successfully fighting the Fed ever since.
The debated role of R* is the next stage, one that is even more dangerous and sinister. From 2007 to 2016 mere incompetence was on display, but ineptitude undertaken at least with an honest purpose. Bernanke did, as Yellen does, what he thought best (the road to hell and all that) using inappropriate tools driven by a limited sense of understanding and a misguided sense of the past (Great “Moderation” somehow chock full of conundrums and gluts). Having been bet against and thoroughly beaten, the Fed aims to excuse its performance but in doing so consigns the world to this state and only this state. To claim that monetary policy as it stands is still useful is to simultaneously claim the economy is irredeemably broken.
Some have called this a liquidity trap, and it is a liquidity trap for sure, but one devoid of liquidity. The central problem is the lack of it, for otherwise banks wouldn’t be bidding -82 bps for German 2s, and the EDM June 2020’s would not be heading to 98.00 yet again – while every curve on earth is pressed so flat as to be unfit for the classification as a curve. All the QE’s in the world have failed to assure the money dealers that it is safe to deal money again (balance sheet capacity); in fact, the very idea of several QE’s often one right after another have instead proven to them that they were right to suspect central banks are indeed toothless, and the liquidity which once was a systemic matter can only be handled as a private individual consideration.
The only use for the R* inference is to further confirm what Dudley said all the way back in 2007. The FOMC has come at least part way around to “their” way of thinking, having wasted ten years and trillions in upheaval in the process. That was no recession in 2008, in no small part because the Fed failed at the very first task it was ever assigned. Until there is a full accounting of that initial failure and all in it, no matter how much time passes in between, we are stuck here in what is like a bad dream of a self-fulfilling mathematical prophecy. It is the only real power the Fed has left, to push the search for a solution to everywhere else except the one place it would actually be found.