The Fed Says

I had the honor of sharing the podium with two distinguished economists yesterday at the 10th Annual Lyons Companies Economic Forecast. Jay Bryson, PhD. is Global Economist with Wells Fargo, and James Bullard PhD. is the President of the St. Louis Fed. Both are brilliant and insightful, in addition to being very nice guys. For this week’s Market Commentary, I thought I would summarize Bullard’s comments to either me or the audience at large. This is not to diminish the importance of Jay Bryson’s presentation. We think Bullard’s comments are most important simply due to his direct role in formulating monetary policy. And following a presentation by Dallas Fed President Richard Fisher that we attended last Friday, we believe the FOMC is becoming increasingly predisposed to begin tightening policy in mid-2015. There are still a couple of hold-outs for sure, but at this point the hawks are firmly in charge.

In contrast to his dovish remarks last October (which caused a rebound in stock prices as they were falling), President Bullard now sounds firmly in the hawks’ camp. The basis for his change of heart is his belief that the economy is no longer in need of “emergency” monetary stimulus. In other words, the Fed can no longer justify zero-bound short-term interest rates as the economy is much closer to “normal” than it has been in years. His upgraded outlook is based on “considerable momentum” in the domestic economy, to include a rapidly improving labor market, strong GDP growth over the past three quarters, better consumer sentiment, and (perhaps most importantly) extremely stimulative interest rates and energy prices. Importantly, President Bullard believes that low interest rates will be with us for a while, strengthening the case for monetary tightening. Below we list some additional points made by President Bullard:

  • Rather than signaling a dramatic slowdown in economic growth, the low level of interest rates in the US is due to the market’s anticipation of Quantitative Easing by the European Central Bank (ECB)
  • The unemployment rate will fall to 5% or lower by the third quarter of 2015
    Inflation and inflation expectations have come down, but the decreases are simply due to the plunge in energy prices; therefore, we should wait until oil prices stabilize before we trust the drop in inflation expectations as measured by the breakeven rate on Treasury Inflation-Protected Securities (TIPS)
  • The economy is pretty close to normal, so rate policy shouldn’t be at zero but rather a little above zero (and still below long-term neutral)
  • In order to maintain optionality, the word “patient” should be removed from the FOMC policy statement; following the initial hike in rates, the FOMC will react to incoming data
  • If the FOMC waits too long to initiate rate hikes, it will get behind and end up having to tighten too fast
  • The consensus at the FOMC is that they do not want to consider selling any of its portfolio of bonds; rather, the FOMC will let the portfolio run off (but only after the rate-hike process has begun)
  • Despite recent strength, the dollar remains close to its historical trade-weighted average
  • The Fed’s tools cannot eliminate the risk of asset bubbles; it’s “macroprudential” tools are untested (an article in the Economist defines macroprudential tools as “targeted rules to reduce instability across the financial system”)
  • The big banks should be split up to eliminate the problem of “too big to fail” (TBTF)
  • Quantitative Easing (QE) is not a panacea; rather, it should be viewed as a “least-bad” option
  • One negative side effect of QE is that it reduces income for people living off interest income (for example, older Americans)
  • There is no bubble in the US economy right now of the magnitude of the housing or tech-stock bubbles; high-yield bonds are an area to watch
  • A good rule of thumb for a sustainable level of national debt-to-GDP is 60%
  • Student loan debt is nowhere near the magnitude of mortgage debt and therefore should not pose systemic problems
  • The pace of tightening should be much more “data dependent” than it was in prior tightening cycles

For our part, we remain unconvinced that the Fed will begin tightening this year. The sheer magnitude of stimulus that has been required to produce 2.0-2.5% growth, combined with the economic weakness outside the US, keeps us in the “show me” camp. My weekly video explains this further. All in all, we’ve heard optimism from Fed Governors, and we hope they’re right!