With market attention focused on what sort of easing the Fed will do on Thursday, talking about Fed hikes may seem a bit outlandish. But I think this is actually a good time to think about it, because both limitations to the Fed’s ability to ease policy as well as the Fed’s willingness to ease policy due to the data suggest that the end game for easing may not be so far away.
Regular readers know that the view here regarding the effectiveness of additional QE on real economic activity is increasingly limited. This view is not particularly out of consensus – Goldman Sachs projects an uptick of just 25-50bps in growth as a result of another round of QE. But this is not a view that appears shared by the Fed, based on Bernanke’s Jackson Hole speech. In fact, attention since then has increasingly shifted toward what the Fed can do after it has to stop balance sheet expansion. (Recall that the Fed is concerned about negative impacts on market functioning if it owns too large of a particular market; more Treasury or MBS purchases would certainly increase that risk) The current thinking is that the Fed can decrease term premiums further by pursuing conditional guidance. For example, Chicago Fed President Evans proposed what he called a 7/3 policy, whereby the Fed commits to not hiking until either unemployment declines below 7% or inflation increases above 3%.
Such a commitment may appear to be a policy easing initially, but if anything, it’s actually the opposite. The current downward trend in unemployment, for example, looks likely to bring unemployment to 7% between 4Q 2013 and 3Q2014. This is almost a year earlier than the FOMC’s likely own projections for the first hike:
In other words, the easing effect of such conditional guidance appears very limited. Of course, the Fed could possibly make policy conditional on nominal GDP, but that’s actually quite unlikely because the Fed’s mandate only includes employment and inflation, NOT GDP growth.
Furthermore, once unemployment declines to 7%, the FOMC’s willingness to ease further will likely decrease sharply. Note that FOMC’s central tendency estimate for NAIRU is 5.2 – 6.0%. Committing to additional easing with unemployment less than 1 percentage point above NAIRU and falling would only make sense if core inflation is well below 2%. In fact, a Taylor rule type estimate for the proper Fed Funds rate actually suggests that the Fed should be prepared to hike in 2014:
There are of course mitigating factors. One is that the Fed may believe the drop in the labor force participation rate is temporary. Certainly some of their research suggests that this is something they are considering. In that scenario, the decline in unemployment would slow as people re-enter the labor force. Another possibility is that the Fed may maintain easy policy for longer due to the upcoming, unavoidable, fiscal tightening. In any case, all of this analysis suggests that fixed income carry & rolldown strategies are likely to work for another year or so. After that, however, it could be a different ballgame.
Here is a final question for your consideration: if conditional guidance does not ease term premiums further, have real yields seen their lows?
- Tues: Canada Housing Starts, Trade Balance
- Wed: UK Jobless Claims, US Import Prices
- Thu: US PPI, Jobless Claims, FOMC
- Fri: EU CPI, Employment, US CPI, Retail Sales