United States: What Would it Take for the Fed to Ease?
Richard Berner (New York)
Some clients and colleagues believe that the Fed has accomplished its anti-inflation mission, and some think that officials may soon contemplate easing monetary policy. Their reasoning is straightforward: "Core" inflation, after rising over the past year, appears to have stabilized or even declined. Advance inflation indicators appear to signal that inflation has peaked. The economy has clearly slowed, indeed, in some industries, appreciably. The dollar is firm in foreign exchange markets, and still serves as an inflation headwind.
Most important for many observers, it's different this time: Productivity growth has again outstripped expectations, and its trend -- as opposed to its cyclical increase -- may yet be increasing. With such productivity gains, they reason, a slowing in growth to 4% might permit inflation to fall. Finally, the bulls point to the inverted yield curve -- at least the Treasury yield curve -- which signals to them that market participants expect the Fed to ease. The parallels with the spring of 1995 are striking -- then, after hiking rates by 50 basis points in February, the Fed began to ease in July. So why won't the Fed now ratify market expectations and take back some of the tightening put in place over the past 13 months?
There's little doubt that the Fed is on hold for the next few months. But barring more profound economic weakness or a financial accident, the Fed is still unlikely to ease anytime soon. Here's why.
First, Fed officials aren't completely persuaded that inflation risks have peaked, though by one measure core inflation declined from 2.2% in the first quarter of 2000 to 1.7% in the spring quarter. For Fed officials, a longer horizon is relevant. For example, measured by the CPI, core inflation rose at a 2.6% annual rate in the first six months of 2000, compared with 1.9% in all of 1999. The Fed's preferred measure -- the "core" PCE chain price index -- rose at a 1.8% annual rate in the first half of this year vs. 1.4% over 1999. Either way, inflation is moving slowly higher. What about the apparent slowing in this index over the most recent three months? We trace it mostly to gyrations in the price data for "services furnished without payment by financial institutions;" e.g., free checking accounts. Fed officials aren't going to change policy based on estimated prices of services for which there is no payment.
To be sure, the Fed eased in the summer of 1995 when core inflation also was moving higher, but then, more convincing forces were in train to bring it down again. At his February 1995 Congressional testimony, Fed Chairman Greenspan noted that "there may come a time" when policy would turn neutral as inflation indicators cooled. The economy slowed dramatically, from a 3.6% rate in the second half of 1994 to a 1.1% pace in the first half of 1995. Even then, the Fed was in no hurry to ease: in the 10 months ended in December of 1995, officials merely unwound the last 50 basis points of tightening. That was then. Today, while the economy has slowed, it is far from stumbling, and doesn't appear to need help from the Fed. The following exchange at his recent Congressional testimony illustrates how untroubled Fed Chairman Greenspan is over Old Economy weakness (see my "The Two-Tier Economy," Global Economic Forum, August 4, 2000):
Senator Sarbanes (D-MD): "...Would you agree that interest rate hikes are having a serious effect on the manufacturing output outside of the information technology sector?"
Greenspan: "Yes, I would... But remember that another reason for that is that there's been a shift of capital out of the so-called old economy into the new economy. So that in a sense you can say if the new technology part of the economy were gone or disappeared we would be left with an economy which was extremely sluggish and scarcely rising at all... But part of that is an issue of merely observing resources going into those areas where the potential rates of return are higher, and indeed you will always find that. If you subtract at any time in history those areas of industrial production which are rising inordinately, the remainder I can assure you will be either negative or flat. And that in itself doesn't tell you very much.."
Bulls argue that the recent acceleration in productivity breaks all the old rules. Mr. Greenspan himself speculated at his recent Congressional testimony that "most of the productivity increase of recent years has been structural, and structural productivity may still be accelerating." With productivity matching the pickup in costs, can there be any inflation risk?
Let us be clear: We agree that the economy's speed limit is significantly higher today than in 1995. But there is a speed limit and it's not 6% growth. The recent acceleration in prices and wages, though gradual, is prima facie evidence that cyclical forces can push and are pushing inflation higher, especially in services less affected by the dollar's strength. If inflation expectations continue to rise, filtering into actual prices and the wage-setting process, and if at least some of the recent productivity rise is cyclical, the recent acceleration in compensation will outlast that in productivity. Even Fed Chairman Greenspan won't bet policy choices based on his hunch that an ongoing acceleration in productivity will save the day. He has described the tactics of policymaking as "a small series of steps that minimize loss" -- a paradigm first articulated by Fed senior staffer Don Kohn in 1989. Thus, there's little urgency to move, and every reason to wait for more data. Nonetheless, bulls may confuse a static Fed with one on the cusp of ease.
As for the message in the yield curve? Fed officials believe that the dynamics of Treasury debt paydowns -- not fears of economic weakness -- are currently the dominant forces shaping the Treasury curve. To be sure, private yield curves have also flattened since the beginning of the year, by some 30 basis points in the spread from 10 years to 2 years. That move partly reflects the shift in expectations about monetary policy and inflation. But the 64 basis point move in the comparable Treasury curve just as clearly reflects the rapid rerating of prospects for debt paydowns and the introduction of Treasury buybacks. Thus, while the Treasury yield curve certainly incorporates market expectations, its shape reflects Treasuries' scarcity premium, and is not a valid benchmark of what's in the market.
What would it take for the Fed to go to a "neutral" stance (that is, where there is no presumption about the direction of risks for inflation or growth)? In all likelihood, more evidence of stable inflation and perhaps growth that slowed convincingly. I reemphasize: That's not our forecast. Such a move would be premature in August, in any case, because policymakers probably will want more evidence, as in 1995, before deciding to make such a shift. And the evidence is mixed: Signs of an improved pace of consumer spending in July retail sales data throw some cold water on the continued slowdown thesis. What would it take for officials to contemplate ease? Dramatic evidence that "the risks were tilted mainly towards slower growth" instead of higher inflation -- or perhaps a shock such that suggested financial conditions were far more restrictive than realized.
And there's the rub for equity investors. The "free lunch" from productivity improvement is probably already in the price. Based on my colleague Joe Mezrich's work, the equity market is priced to the Goldilocks scenario of enough growth to validate bullish earnings expectations but no increase in inflation. Yet, the circumstances that could prompt Fed ease and lower rates are precisely those that will produce a significant deceleration in earnings. Maybe Goldilocks has just left the building.
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Japan: BoJ Flirts with Pandora
Takehiro Sato / Robert Alan Feldman
Was the Hike Justified?
The BoJ justified the 0.25% rate increase on its judgment (a) that deflationary expectations have been dispelled, (b) that downward pressure on prices from weak demand is over, and (c) that sentiment in financial markets has stabilized, despite recent bankruptcies. However, the very widespread judgment among investors and the general public that a rate hike would be premature now puts an onus on the BoJ to explain why its judgment was correct.
We believe that macroeconomic conditions do not justify the hike. In particular, many inflation indicators continue to deteriorate, or to stay solidly in negative territory on a year-on-year basis. The BoJ nevertheless insists that deflation fears have abated, on the grounds that demand-induced deflation is over and that only supply-induced deflation is occurring. Having said this, and having used the distinction as part of the justification for the move, the BoJ must quickly produce clear definitions of what constitutes demand-side and supply-side deflation, in order to retain credibility.
In addition, senior BoJ officials have repeatedly referred to the need to watch consumption and income trends in order to be certain of economic recovery. In the statement made after the hike, however, the BoJ omitted any mention of consumption or income growth, and retreated to saying only that most of the recovery is based on business investment. In order to retain credibility, the BoJ must now explain why it dropped consumption and income growth from its explanation of the rate hike.
The supporters of an early end to the zero interest rate policy (ZIRP) have said that the "moral hazard" of the policy was supporting zombie firms that should not exist in an efficient economy. It is interesting that the BoJ did NOT use this argument to justify the rate hike, despite Gov. Hayami’s repeated references to the moral hazard issue. In view of the omission of this factor from the BoJ announcement despite the Governor’s statements, there may be skepticism among investors about whether the BoJ has been fully frank about the reasons for its policy change.
The Next Move Is Up, with the Return of Risk Premia
Initial reaction of financial markets has been subdued, in part because of the holiday season, and also because most commentators poo-poo the idea that a 25bp rate hike is significant. We beg to differ. First, most investors will conclude that the next move is up. Thus, there are likely to be "next hike" premia creeping back into term rates. After all, Gov. Hayami said in his post rate-hike press conference that, "We have not attached any particular conditions for future changes in monetary policy." Optimists may hope that this means BoJ could return to ZIRP if conditions worsen. But the statements could equally mean that BoJ will hike whenever it wants. Second, the BoJ action also shifts the philosophy of rate determination away from easing the pain of structural reform and toward cyclical factors. The BoJ was willing to take the risk that the hike would accelerate and deepen structural adjustments. Thus, the weight of these factors in policy determination has fallen.
In addition to "next hike" premia, the move from zero to 25bp for the call rate will also re-introduce various risk premia into the money markets. Credit premia have been zero since ZIRP began, because under this policy all borrowers in the call market could count on repayment. Term premia will return as well, since liquidity risk now exists again. And the "time axis" effect, which held rates down because of BoJ’s commitment to ZIRP "until deflation fears are dispelled" has now vanished.
Putting these factors together, we think that the rise of term rates in reaction to the BoJ rate hike will likely range between 40-60bp. With money market rates higher, the volatility of bond yields is also likely to rise. Throughout 2000, the standard deviation of the 100-day moving average of the benchmark bond yield has been less than 10 bp, compared to the long-term average (since 1986) of 26 bp. The end of ZIRP most likely signals that sustained low levels of yield volatility are probably over. With the duration exposure of financial institutions already up significantly as a result of heavy JGB purchases, the extra volatility may generate a further shift toward the short end of the curve, with the result of an overall steepening.
BoJ Has Re-Opened Pandora’s Box
In our judgment, the BoJ rate hike will re-open the Pandora’s box of structural problems in the Japanese economy. In particular, the problems in real estate, construction, retail, and other troubled sectors have already come back into investor consciousness as the result of several large bankruptcies recently. While 25 bp may not seem like a large rate hike, it will make the strategy of slow, steady workout that much harder to achieve.
Financial institutions are in a particularly difficult position, having promised the government to raise loan spreads, raise lending to small business, and improve profits -- and now facing an environment of higher market rates. The financial institutions cannot raise deposit rates, hold loan rates constant, and still raise spreads and profits all at the same time. The rate hike also presents the corporate sector (particularly very small business) with problems. In order to offset the effect of higher interest costs on profits, companies will have to take action. Potential actions include squeezing suppliers, cutting wages, more outsourcing, and more imports. Moreover, lenders will be more cautious in lending to small business that will be under increased pressure. Although unlikely to be as deep as in 1997-98, some degree of credit crunch could return to the Japanese loan market.
Angry Government, Critical Markets
The government believes that the BoJ action was premature and could raise risks to the economic recovery. The reaction from other parts of the government is likely to include (1) sharply critical rhetoric against the BoJ action, and (2) consideration of somewhat larger fiscal spending and increased credit relief programs. Both of these actions could cause disturbances in markets.
Japanese commentators have been critical of the BoJ action on several points. First, even those commentators who thought the rate hike appropriate fault the BoJ for not making its criteria of judgment clear. Second, commentators have been unanimously critical of the adversarial way in which the rate hike decision was made. Third, most Japanese investors believe that the BoJ’s desire to prove its independence interfered with its judgment about macroeconomic conditions. The criticism of the BoJ will likely lower confidence in policymaking, and raise volatility in all asset markets.
The Hike and the GDP Outlook
The BoJ hike will worsen the macroeconomic outlook. Already, on the assumption of continuation of the zero rate policy, we had been predicting a significant slowdown from the second half of the year. The rate hike will likely exacerbate the slowdown. It is difficult to quantify the effect at this point. Already, our current forecast of -0.4% growth for FY01 is the only negative growth forecast, and compares with the current consensus of 1.8%. Thus, we hesitate to make a further downward revision. Our point is that the depth of the structural problems will reemerge, and constrain growth severely. The rate hike increases the changes that the consensus will move in our direction. |
