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New Federal Reserve Paradigm
US equity indexes staged a sharp positive reversal since last Thursday morning following the tragic murder of British MP Jo Cox, subsequent currency market moves, and polling indicating Brexit is less likely.
Financial markets abhor uncertainty and there are few things more uncertain right now than the fate the Brexit referendum so it is intuitive that polling favoring the status quo supports higher equity prices. However, there are other forces at work that may prove much more volatile to US markets than the potential outcomes of the Brexit referendum.
Early Friday morning June 17, James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, discussed a point paper with potentially huge market implications: The St. Louis Fed’s New Characterization of the Outlook for the U.S. Economy.
Overview
The Federal Reserve Bank of St. Louis is changing its characterization of the U.S. macroeconomic and monetary policy outlook. An older narrative that the Bank has been using since the financial crisis ended has now likely outlived its usefulness, and so it is being replaced by a new narrative. The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes. The concept of a single, long-run steady state to which the economy is converging is abandoned, and is replaced by a set of possible regimes that the economy may visit. Regimes are generally viewed as persistent, and optimal monetary policy is viewed as regime dependent. Switches between regimes are viewed as not forecastable.
The upshot is that the new approach delivers a very simple forecast of U.S. macroeconomic outcomes over the next 2 ½ years. Over this horizon, the forecast is for real output growth of 2 percent, an unemployment rate of 4.7 percent, and trimmed-mean PCE inflation of 2 percent. In light of this new approach and the associated forecast, the appropriate regime-dependent policy rate path is 63 basis points over the forecast horizon. The discussion below describes how this regime could be upset by switches in fundamental factors that may cause changes in the recommended policy path setting.
The source and timing of the paper’s release are curious. Among money managers and traders that follow the Fed few of them I talk to hold Mr. Bullard in high regard. He is a very visible President and known for moving markets during interviews, especially during swift equity market corrections. He is alternately known as the Chairman of the Federal Open Mouth Committee.
The St. Louis Fed is best known for its Federal Reserve Economic Data (FRED) website. Ricochet Contributors and Members frequently cite FRED when writing on economics. I’ve not previously considered Mr. Bullard or the St. Louis Fed a go to source for long term Federal Reserve policy guidance. Historically, that has been the purview of the Chairperson or the NY Fed.
The document was posted to the St. Louis Fed’s website Thursday night and Mr. Bullard appeared on CNBC Friday morning to discuss it dropping a bombshell in contrast to his previous appearances. Mr. Bullard indicated the FOMC raising short-term rates at most once between now and 2018. This apparent new commitment to more accommodative policy published in writing and contradicting previous protestations of Loretta Mester of Cleveland and Ester George of Kansas City is a market bombshell the short-term effects of which are muddled with the Brexit Referendum.
The release late Thursday night and absence of formal introduction and press conference raises many questions as to how much this document is James Bullard freelancing and how much of it is Federal Reserve endorsed policy. That he issued it in writing lends credibility that this may be formal Federal Reserve policy.
Federal Open Market Committee Chairwoman Janet Yellen testifies before the Senate, Tuesday, June 21, and the House of Representatives Wednesday, June 22. It will be interesting to see if she refers to Mr. Bullard’s new regime document or if she is questioned about it. Releasing the paper so close to her testimony leaves Congress little time to prepare interrogatories on the matter.
Expect more than usual volatility as this paper is factored into the markets and Mrs. Yellen testifies. Be careful out there.
Disclosure: No Positions.
Published in General
That is a rather remarkable document to be released with no fanfare. Could this be viewed as Mr Bullard floating new policy ideas on his own without causing market shifts that would occur had it come from NY or the Chariwoman?
That is a very distinct possibility. It is hard for me to believe he did this without her knowing.
He is the market moving canary in a coal mine and is used extensively to shift markets and this may be another example but to put it in writing is remarkable.
This is a major shift in fed policy so I think you’re right here. This is the equivalent of a president floating a policy shift with a third party editorial in the Times.
I’ve always found it remarkable that economics, which is filled to the brim with numbers and graphs and “experts,” still moves herd-like at the raising of certain eyebrows. For years, the expert financial analysts would compile reams of reports and statistics, and yet if Greenspan coughed at the wrong time, the markets would ignore all the numbers and go into a panic.
And these are the same people who are … every month … surprised by the latest job statistics or GDP output.
Regime-switching is actually a more robust way to model long-term economic behavior. I’ve used such models in my work and I’m glad to see the Fed might be too.
As far as where policy rates go… I still maintain that we will not see material hikes in our lifetime. We are in a long-term low-growth, deflationary spiral driven by demographic factors. The only way to combat this is to unleash incentives to innovation and risk-taking by radically paring back the regulatory state. And that isn’t going to happen.
I always assume there is some coordination on these things. Greenspan used to do his own obfuscation while appearing to be transparent. Bernanke & now Yellen rely on others to mix the signals.
I’m not saying it is coordination only that I assume that it is. There I just made that more opaque.
Btw, thanks for pointing me to the Bullard statement. With an anti-growth fiscal policy we’re now coming up on the 8th year of “emergency” monetary policy. Pathetic.
My favorite was back in the day when CNBC would try to figure out rate policy by how think Greenspan’s briefcase was.
Economics is the dismal science. Applied psychology and sociology. This isn’t surprising.
The problem is the fed band aid is going to hurt like the dickens when it’s ripped off in a decade or so.
It will never be ripped off. That’s my point. Interest rates will go negative, and stay there.
A bold prediction. I hope you’re wrong.
At some point after years of negative rates or other extraordinary measures confidence in the currency wanes.
The U.S. probably won’t last long enough for it to matter.
America may last, but I doubt it will be a United States.
I’m not usually a day trader, but I’m currently trying to drastically change my investments which means I have to sell much of my US positions which have approximately doubled since the 2008/9 market crash. I was afraid we had reached the peak two weeks ago (which still might be true), but I’m glad I didn’t chicken out when the markets were struggling last week since it seems like people really want to move the market higher right now despite all the bad economic data and last week’s releases prevented the markets from doing that.
There’s another way to combat this that also doesn’t look likely for the foreseeable future. Have more babies and increase immigration!
Which will be offset by yet more spending on government goodies and welfare.
OK, BRB
More people is still a net positive externality. :)
Excellent piece. Thanks BrentB67.
Would like to see even more analysis so I can stop paying 125 basis points to a “portfolio manager.”
I know, index funds.
Wow, that’s expensive. I don’t anticipate charging that much (and less as my clients assets grow), and I hope to do better than static index investing without “active trading.”
It seems about the going rate for full service (planning, etc.) in my area, although, in fairness, it would be less if I gave them more $$$. My significant other thinks it’s a good idea in order to tone down my more aggressive (i.e., shorting) instincts.
That’s true. If your instincts are to basically gamble on an unlikely event, a 1.25% hit might still make you come out on top.
Forever?
I charge less than that too.
My view is that they will stay there at least until some other country’s bonds become the benchmark, possibly longer. As I wrote above, I don’t believe they will go materially higher in our lifetime.
You may be right. I’m just always skeptical when it comes to predicting things that far out. Over the long term, unexpected shocks are, um, sortof . . . expected.
Agreed, but you have to make long-term decisions on the basis of some forecast, explicit or not.
There is a long-term macroeconomic identity, under reasonable simplifying assumptions, that in equilibrium a government’s nominal bond yields will converge to that country’s nominal GDP growth rate. I see large systemic barriers to US GDP growth. There could be a positive shock, but I’m not banking on it.
Peter Schiff. I fear he’s calling it right – again.
You guys are good. Makes me reminisce about Rukeyser and his “bond ghouls” (no offense).