With the pickup in global economic growth, central banks -- except for Japan’s -- are shifting to tightening from extremely easy money, including massive quantitative easing and trivial, if not negative, short-term interest rates. The Federal Reserve has raised its target for the federal funds rate five times since December 2015 and is suggesting three more increases this year.
But the Fed is confronted with a serious dilemma: Inflation and wage increases continue to undershoot its expectations at the same time the central bank confronts forces pressuring it toward credit tightening.
The new chairman, Jerome Powell, who isn’t a trained economist, may change the central bank’s tone, but his soon-to-be predecessor Janet Yellen and the other academic economists who have dominated monetary policy, believe fervently in the theoretical Phillips Curve. It posits that a declining unemployment rate should spur inflation, despite evidence to the contrary. Rather than increase as the unemployment rate declined since the recession, the rate of inflation has largely stayed the same.
Nevertheless, the Fed wants to tighten credit slowly due to chronic low inflation and memories of the May 2013 “taper tantrum,” when a mere mention by then-Chairman Ben Bernanke of reducing the Fed’s rate of asset purchases sent financial markets into tailspins as interest rates leaped.
Another reason for the Fed to tighten is to keep commercial banks from lending out the more than $2 trillion in excess reserves the Fed has given them through quantitative easing. These are simply an asset of the banks and a liability on the Fed balance sheet with little financial or economic consequences. But as economic growth picks up as a result of the tax cuts followed by likely massive fiscal stimulus, creditworthy borrowers will want to borrow, banks will be happy to lend and these excess reserves could turn into tons of money that would threaten major inflation.
The Fed is also concerned about market distortions caused by low rates. The problem isn’t low rates, per se, but investors' unwillingness to accept them despite the offsetting effects of low inflation. Adjusted for inflation, the 30-year Treasury bond yields 0.62 percent, lower than the 1.7 percent average of the last decade but not hugely so. Nevertheless, many investors and savers believe they deserve much higher returns than the 2.97 percent current yield on the 30-year Treasury and 2.73 percent on the 10-year note. So they’ve moved further out on the risk spectrum into assets such as emerging-market bonds, student debts despite high delinquency rates and leveraged loans, to name but a few.
Fed officials, while they believe that in a normal, stable economy, the fed funds rate should be around 3 percent compared to the present 1.25 percent to 1.5 percent range, are also gradually adjusting to reality. They’re suggesting that it may be appropriate for rates to be lower for longer.
I remain convinced that a key reason the Fed has raised rates is because its credibility was at stake, and remains so. It has repeatedly forecast higher fed funds rates than it subsequently initiated. Bear in mind that the Fed controls that rate so it simply didn’t do what it intended. The gap between its fed funds forecasts and actions are extraordinarily wide, ranging to more than four percentage points.
Despite Powell's suggestion that the economy has not run out of slack, the majority of policy makers may worry that the tax cuts could prove stimulative enough to cause major economic strains. In addition, Republican plans for major infrastructure outlays will no doubt concern the Fed about an overheated economy. And that’s despite the likelihood that the actual spending won’t take place for several years.
Historically, once the Fed starts to raise rates it almost always continues until it precipitates a recession and a bear market in stocks. By my count, in 11 of 12 times since World War II, a recession followed a rate-raising campaign, though it can often take years for that to happen. The only soft landing was in the mid-1990s. This time, with so much excess liquidity around the world, it may also take years before higher rates and a reduction in the Fed’s balance sheet assets start to pinch the economy.
The yield curve -- the spread between short- and long-term Treasury rates -- may also behave differently this time. In the past, when the Fed jacked up rates to the point that yields on 2-year Treasuries exceeded those on 10-year notes, the yield curve “inverted” and a recession followed. Inversions typically occurred because 2-year yields rose faster than 10-year yields. Recently, however, the spread has narrowed because 2-year yields have risen but 10-year yields have been relatively stable. That’s unusual but probably reflects deflationary pressures that are more evident in longer maturities.
So, if an inverted yield curve occurs, it may not, as in the past, guarantee a nearby recession, and it may take years before Fed tightening precipitates one.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.”
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