Global Central Bank Focus

r*=New Neutral

The Federal Reserve’s baseline view of a rate-hike trajectory is consistent with PIMCO’s New Neutral thesis about the neutral policy rate.

In case there was any doubt about the Federal Reserve’s intent when it released a statement on October 28 that made reference (for the first time since 1999) to the possibility that economic conditions might warrant hiking interest rates at the “next meeting,” Chair Janet Yellen just a week later on November 4 dispelled that doubt when, in testimony before Congress, she indicated that hiking rates at the December 15–16 Fed meeting was a “live possibility.” The question then becomes: If the December meeting is “live,” what about the ones that follow?

Enough hard data, at last
On November 6, just two days after Yellen’s testimony, the employment report for October was released and it showed a much larger than expected gain in payrolls of 271,000, as well as substantial upward revisions to the employment gains reported in previous months. However, of perhaps even greater significance to the Fed call – ours and theirs – the October employment report also showed a much stronger than expected gain in average hourly earnings, which in October were a full 2.5% higher than one year ago. Importantly, Chair Yellen in her November 4 testimony indicated that she herself expected that inflation will rise to the 2% target in coming years, and so the release of the wage inflation data for October could only have reinforced that expectation.

The Fed has now for many months written that it needs to see “continued progress” in the labor market and that it also needs to have “reasonable confidence” that under appropriate policy, inflation will rise back to the 2% target the Fed first set in 2012. With this employment and wage report, and with measures of core inflation already starting to rebound from the depressed levels reported earlier this year, the Fed at last has the hard data it says it needs to justify lifting rates off the zero bound to which they have been pinned since December 2008 in the darkest days of the global financial crisis. Indeed, I doubt there is any plausibly probable data on the U.S. economy that could be released between now and December 16 that could cause the Fed to punt in December and delay a rate hike until 2016. That said, there are global developments – a hard landing in China with serious contagion to global markets, for example, or a geopolitical explosion in the Middle East – that could persuade the Fed, on risk management grounds, to keep rates unchanged. These are – hopefully – tail events, and so the baseline view in markets and at PIMCO has converged to a very high probability that – at last – the Fed begins the process of liftoff.

Blue dots suggest a baseline trajectory
But liftoff at what pace, and to which destination? In the June 2015 Global Central Bank Focus, I wrote that while data dependence in and of itself is not a monetary policy – and it still isn’t! – the Fed “blue dot” chart (Figure 1) can, under certain plausible assumptions, tell us a lot about liftoff under the Fed’s baseline scenario as summarized in its quarterly Summary of Economic Projections (SEP). The dot plot released in September shows a very gradual liftoff path rising to a historically low destination. Along this path, rates rise by about 100 basis points in 2016 and by another 100 basis points in 2017. This amounts to four 25 basis point hikes per year over the first two years of normalization. Note that the dot plot the Fed releases does not specify the views of individual FOMC (Federal Open Market Committee) members, but by analyzing these individuals’ stances and statements, one can make an educated estimate on their specific views of the rate path, as shown in this figure.

Figure 1 is a plot of policy rate estimates of the 17 participants of the Federal Open Market Committee for 2015 through 2018, and also the longer run. PIMCO assumptions about the identity of the participant making each estimate are indicated next to each “dot.” Generally, the graph shows how the FOMC expects the rate to rise through 2018, then level off. Over time, the range of expected rates widens, to roughly 300 basis points in 2016 and 2017, up from 100 basis points in 2015. The midpoint keeps rising each year, to about 1.25% in 2016, 2.5% in 2017, 3.25% in 2018, and 3.5% for the longer run. PIMCO’s assumption about Federal Reserve Chair Janet Yellen’s name is highlighted for each year, and her estimates are either in the middle of the range, or just below it.

Possible consequences of the live meeting message
Conveniently, although the Fed meets eight times per year, only four of these meeting are followed by a scheduled press conference, and so there will be the expectation by markets that the Fed will be hiking at every other meeting for at least the next two years. The Fed, I’m sure, will – as it has in the past – resist this interpretation and will continue to indicate that every meeting is “live,” including the four meetings per year when no press conference is scheduled.

But as liftoff commences the Fed may well find that there is a cost – in terms of increased market volatility and excess sensitivity to noisy data – to an every-meeting-is-live communication strategy that seeks to maintain maximum optionality. As basic finance teaches us, a long option position must always have a positive price, and to the extent the Fed ignores this lesson, it may find itself tempted to revert yet again to some form of calendar-based guidance, which works precisely because it links rate expectations to the passage of time and not to the realization of daily data releases.

Implications of a gradual normalization cycle
How should we interpret the baseline blue dot liftoff path of four hikes per year given that the prior, pre-crisis rate cycle under Alan Greenspan and Ben Bernanke between June 2004 and June 2006 featured a 25 basis point rate hike at every meeting for 17 consecutive meetings? Are the dots telling us that the Fed plans and will be content to be behind the curve for the next two or three years, keeping rates below an unchanged constant-for-all-time neutral policy rate? The answer is No! Chair Yellen knows it is crucial to communicate why the upcoming rate normalization cycle is likely to be the most gradual in history, and building on the thesis first laid out by Ben Bernanke in September 2013, she did so masterfully in a speech at the San Francisco Fed in March 2015. In that speech, Yellen explained that liftoff will be gradual not because the Fed plans or desires to be behind the curve, but because the “equilibrium” real policy rate itself is time varying, is at present well below the level that prevailed before the crisis and that is assumed in the classic 1993 Taylor rule, and is itself expected to rise only gradually over the next several years, and even then to a level well below what prevailed before the crisis. Thus, according to Yellen, liftoff will be very gradual not because the Fed plans to be behind the curve, but instead because the neutral rate itself is depressed and is expected to rise only gradually over time. In its essence, the Yellen rationale for gradual lift coincides with The New Neutral thesis introduced by PIMCO at our May 2014 Secular Forum, and discussed in detail in “Navigating the New Neutral” in November 2014. An important disclosure in the minutes of the October 28 meeting (released on November 18) is that the Fed staff has done an exhaustive study of the “neutral” real policy rate (and yes, they do use that term!) – which they denote by “r*” – and they conclude, much as Yellen alluded to in her speech, that 1) it is time varying, 2) it is about 0% right now, 3) it is expected to rise only “gradually” over time and 4) it is unlikely to rise to levels seen before the financial crisis. Moreover, a number of participants at the October FOMC meeting agreed with this conclusion.

Why is this important? It is important because in the SEP projections that accompany the dots, inflation is expected to rise gradually to a 2% rate over the next two years and then stabilize at that target. If the Fed really thought there was no New Neutral and that the equilibrium real policy rate was constant and equal to its pre-crisis level of 2%, its projections would be forecasting a significant inflation overshoot. They do not, and neither does the Fed staff’s FRB/US model.

In sum, under the Fed’s baseline view of the economy, the Fed rate-hike trajectory through well into 2018 is consistent with our New Neutral thesis that the time varying neutral policy rate lies in the range of 2% to 3% nominal and 0% to 1% real. Now it is true that the dots tell us that eventually – in 2019! – the Fed would like to raise the federal funds rate to 3.5%. At PIMCO we are skeptical that over the next five years the riskless real return on cash will reach 1.5%. Investors will likely be able to earn 1.5% after inflation, but only by taking on duration, credit, equity or volatility risk.

The Author

Richard Clarida

Former Global Strategic Advisor, 2006-2018

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