Must-Read: Tim Duy: Fed Once Again Overtaken by Events

Must-Read: That the Brexit crisis would happen was unforeseeable. That the odds were strongly that some negative shock would hit the global economy was very foreseeable indeed. And yet the Fed since 2014 has been actively making sure that it is unprepared.

10 Year Treasury Constant Maturity Rate FRED St Louis Fed

Starting with Bernanke’s abandonment in 2013 of a policy bias toward further expansion and acceptance of a need for interest rate normalization and the resulting Taper Tantrum, there has been a dispute between the markets and the Fed. The markets have expected the Federal Reserve to try to normalize interest rates and fail, as the economy turns out to be too weak to sustain higher rates. The Federal Reserve has always expected to be able in less than a year or so to successfully liftoff from zero and embark on a tightening cycle, raising interest rates by about one percentage point per year.

The markets have been right. Always:

Tim Duy: Fed Once Again Overtaken By Events: “A July hike was already out of the question before Brexit, while September was never more than tenuous…

…Now September has moved from tenuous to ‘what are you thinking?’… as market participants weigh the possibility of a rate cut…. Internally they are probably increasingly regretting the unforced error of their own–last December’s rate hike…. Uncertainty looks to dominate in the near term. And market participants hate uncertainty. The subsequent rush to safe assets… is evident…. Direct action depends on the length and depth of the financial turmoil currently underway. I think the Fed is far more primed to deliver such action than they were a year ago. And that… will minimize the domestic damage from Brexit.

The Fed began 2015 under the direction of a fairly hawkish contingent that viewed rate hikes as necessary to be ahead of the curve on inflation. Better to raise preemptively than risk a sharper pace of rate hikes in the future…. [But] asset markets were telling exactly the opposite, that there was far less accommodation than the Fed believed. Fed hawks were slow to realize this, and, despite the financial turmoil of last summer, forced through a rate hike in December. I think this rate hike had more to do with a perceived need to be seen as ‘credible’ rather than based in economic necessity. I suspect doves followed through in a show of unity for Chair Janet Yellen. They should have dissented.

Markets stumbled again in the early months of 2016, and, surprisingly, Fed hawks remained undeterred. Federal Reserve Vice Governor Stanley Fischer scolded financial market participants for what he thought was an overly dovish expected rate path. And even as recently as prior to the June meeting, Fed speakers were highlighting the possibility of a June rate hike, evidently with the only goal being to force the market odds of a rate hike higher. But I think that as of the June FOMC meeting, the hawkish contingent has been rendered effectively impotent…. I suspect the Fed will be much more responsive to the signal told by the substantial drop in long-term yields that began last Friday (as I write the 10 year is hovering about 1.46%) then they may have been a year ago….

I expect some or all of…. Forward guidance I. Fed speakers will concur with financial market participants that policy is on hold until the dust begins to settle…. Forward guidance II…. Watch for the balance of risks to reappear – it seems reasonable to believe they have shifted decidedly to the downside. Forward guidance III. This would be an opportune time for Chicago Federal Reserve President Charles Evans to push through Evans Rule 2.0. No rate hike until core inflation hits 2% year-over-year…. Forward guidance IV. A lower path of dots in the next Summary of Economic projections to validate market expectations…. Rate cut. Former Minneapolis Federal Reserve President Narayana Kocherlakota argues that the Fed should just move forward with a rate cut in July. I concur…. If all else fails. If some combination of 1 through 5 were to fail, the Fed will turn to more QE and/or negative rates…

I am thinking of Stan Fischer on January 5, 2016 on interest rates:

Well, we watch what the market thinks, but we can’t be led by what the market thinks. We’ve got to make our own analysis. We make our own analysis, and our analysis says that the market is underestimating where we are going to be. You know, you can’t rule out that there is some probability they are right because there’s uncertainty. But we think that they are too low…

Even though the markets had been right and the Fed wrong for the previous three years, as of January 2016 Fischer was claiming that market expectations were irrationally pessimistic and that the Fed understood the state of the economy.

I would very much like to hear Stan Fischer give a speech early next month laying out how he has over the past six months marked to market his beliefs about the state of the economy and the correct economic model.

June 28, 2016


Brad DeLong
Connect with us!

Explore the Equitable Growth network of experts around the country and get answers to today's most pressing questions!

Get in Touch