Back in December of last year, in the midst of the downdraft of oil, I wrote that the deflation in headline prices we were about to see was symmetrically opposite to what we saw in the energy-driven headline inflation during 2011:
In April of 2011, Ben Bernanke was universally lambasted and lampooned for claiming that inflation, which was accelerating and running above 3%, was “transitory”. He used this view to justify loosening monetary policy. The next few months of CPI were not favourable to the Fed chairman’s views: it peaked at 3.8% (nearly double the implicit target at that point) in September of 2011, sparking a feverishly pitched cacophony of criticism that the Fed chair was out of touch, and tone-deaf in his theoretical ivory tower to the practical realities on the ground.
This, however, proved to be Bernanke’s finest hour. Yes, even more so than the extraordinary measures taken during the height of the credit crisis. His detractors then, of which there were still many, included people and institutions on the brink that needed the Fed to extend them a hand. In September of 2011, the chairman stood very much alone in his call for moderated inflation now that the acute disaster removed influential institutions and people from needing the Fed to act in order to survive.
Oil has fallen farther and faster than most anyone, including I, anticipated. Headline CPI has consequently been nudged farther into negative territory than I’d expected. But what hasn’t happened: the deflation in oil has not bled into everything else, causing a broad and general price decline. Wages have accelerated. Median and trimmed mean measurements of CPI have already recovered — and exceeded — the 2% inflation target. The largest component of spending and price indexes, shelter, continues to accelerate, and is now at the fastest inflation rate since 2008.
Perhaps most convincingly, even headline CPI m/m annualized has normalised, despite the Sturm und Drang of the energy component. But, as I’ll argue further, investors and the Federal Reserve are far better off served consuming their energy from the Sturm und Drang period of Haydn.
The Taylor Rule is the most eloquent expression of monetary policy in the United States. It explains that interest rates should be optimized on two variables: inflation, and how far national income is from potential output. There is a third term, of course: the natural real rate. It is often supposed to be 2% in the long-run, and perhaps this is a reasonable assumption.
This is where we get disagreement amongst practitioners. If we were to take the common 2% natural real rate assumption as static fact, we have actually long been ready to hike:
Indeed, a small fraction of poor interpreters of the Taylor Rule have called for hiking as early as 2011. We know with reasonable certainty that the Federal Reserve made a spectacular call — and one that the European Central Bank simultaneously blew — to hold rates on account of the transitory energy inflation. The natural real rate was most certainly not 2%. Most importantly, the nature of the transitory energy-driven inflation is that it is actually detrimental to the natural real rate.
If energy-driven headline inflation is detrimental to natural rate, then an energy-driven headline deflation may in fact be constructive to the natural real rate. The most concrete reasoning we can estimate that the natural real rate is greater than 0%, however, is in the loan growth data.
It’s tricky to say exactly how high it would be. Ask yourself this: how elastic would those series be to changes to the Fed Funds rate?
The answer is: not very. Why? Because these liabilities are not priced at the cash rate. Corporate bonds, auto loans, mortgages, and the vast majority of economic sensitive lending are benchmarked off 5s, 10s and 30s. The Federal Funds Rate for next quarter barely matters, unless it is really wrong.
5s, 10s and 30s lifted off from ZIRP two years ago:
They initially lifted off somewhat excessively (as I pointed out in my August 21, 2013 piece). Short rates are going up already. Belly rates will be the sum of expectations on the short rates. Long rates will be more about reinvestment policy for the foreseeable future.
Economically sensitive borrowing has long forgotten about ZIRP — even with this downdraft in inflation expectations. That’s why it’s time to start assuming the natural real rate is no longer 0% — and if that’s no longer 0%, then by most accepted functions, such as the Taylor Rule, ZIRP is no longer appropriate.
The only excuse not to hike we are left with is the lack of apparent urgency to do it, as my friend Igor suggests:
@mbusigin can you give any reason why they would raise rates? To fight inflation? Zirp doesn't hurt
— Igor (@Petsamo971) August 22, 2015
I have each of a theoretical and empirical argument. We actually have no idea if ZIRP is hurting us – and we won’t until the after the fact. The Fed is not a purely reactionary institution, and it shouldn’t be. Rather, it has historically taken upon itself the obligation to smooth out the cycles, exchanging amplitude for magnitude, preferring longer, shallower cycles over shorter, deeper cycles. The idea is to hike earlier into strength so you don’t have to hike later into weakness.
But my best argument is an empirical one. I estimate how loose monetary and fiscal policy are relative to the variables used as inputs into their policy: unemployment, the output gap and inflation:
For the macro variables as they currently stand, both monetary and fiscal policy are looser than their historical analogues. Monetary policy is particularly loose: around 1.8% looser than similar conditions historically.
The first few hikes are not a binary switch that flip us to tight policy. The tightening cycle already began during the Taper Tantrum. A 25bps hike in the Fed Funds rate is but a small adjustment to an analogue dial which has been already long expected by longer interest rates. Monetary policy will still be phenomenally — historically — loose.
I don’t know if the Fed will hike in September. Before very recently, I’d have guessed that it will. But they should. And, after the brief Sturm und Drang, the last vestige of the financial crisis will sneak out the back door and go home to his place in the economic history books. Hopefully it will not be viewed as too late, but it will join its long-time friend, fiscal policy, who left the party too soon.