Torsten Slok says:

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And Tim Duy says:

Tim Duy: Challenging the Fed: Both Paul Krugman and Ryan Avent are pushing back on the Federal Reserve’s apparent intent to raise rates in the middle of next year. Why is the Fed heading in this direction?… I don’t think that the Fed is reacting to external criticism.

What I think is that there are two basic views of the world. In one view, the post-2007 malaise is simply the hangover from a severe financial crisis. Time heals all wounds, including this one, and the recent data suggests such healing is underway.

The alternative view is that the economy is suffering from secular secular stagnation… suggests the need for a very low or negative real interest rates to maintain full employment…. I believe that the consensus view on the Fed is the former, that the malaise is simply temporary (“a temporary inconvenience”) and now ending…. The Summary of Economic Projections[‘s] implied equilibrium Federal Funds rate is around 3.75%… below what might have been perceived as normal ten years ago… [but from] slower potential growth rather than secluar stagnation….

Gavin Davies… catches… Stanley Fischer… reject[ing] the main monetary policy implication of the secular stagnation hypothesis…. I find it hard to believe that Fischer carries anything but extreme intellectual weight within the Fed…. This is not to say that I do not share Krugman’s and Avent’s concerns. I most certainly do….

If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week’s press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?

As Torsten Slok points out, 10-Year Treasury yields are now where they were in September 2011, when the Fed Funds futures told us that it was 24 months until the first Federal Reserve rate hike, even though right now Federal Funds futures are telling us that the market expects the first Federal Reserve rate hike to come in eight months.

Since the start of 2009, the 10-Year Treasury and the Federal Funds futures have traded in a pattern in which a one-month acceleration in the relative timing of the first rate hike is associated with a ten-basis-point–an 0.1%-point–increase in the 10-Year Treasury rate. Right now the 10-Year Treasury diverges from that pattern by 160 basis points–by 1.6%-point.

That means one of two things, or a mixture:

  1. The bond market expects that the long-term nominal interest rate at which Federal Funds will settle post-normalization is 1.6% points lower than the 4.5% or so it expected back in those halcyon days before last January.

  2. The bond market expects a roughly 50% chance that the Federal Reserve’s attempt to normalize interest rates will fail, and that in two or three years the Federal Reserve will find itself doing a Sweden–cutting the short-term safe nominal interest rate back to zero again, and so reentering the liquidity tap.

Given the balance of risks, the FOMC would have to be discounting the possibility of option (2) and that the bond market’s view of the world is correct by roughly 100% for it to continue on its current policy path.