In Bill's World Asset Price Inflation is Easy

The Federal Reserve has revised up its economic forecast for 2021 as far as it dares. But for all of this optimism, and at 6.5% real GDP growth, it is predicting the most vigorous growth since 1992, when the economy was throwing off the shackles of the Savings and Loans bust, its forecasts for this year are still materially below consensus forecasts. In the wake of the two fiscal packages, totalling nearly 14% of GDP and evidence that consumers have built up savings of more than $1.6tr during the pandemic, investment banks are competing to forecast the strongest growth rates for 2021. I still think that these market forecasts, which are rising north of 8%, are still too low. Economists are intimidated by large numbers, but the massive stimulus and pent-up demand suggest that annualised growth will be stronger still.

The risk for the Fed is that this strength is immediate. Citibank's US economic surprise index has dropped to its lowest level since last June as recent data has disappointed, but this is temporary. The surprise index measures the economic data outcomes against both the market consensus and its level three months ago. It is mean-reverting by design and was developed to generate trading revenue for Citi rather than be the essential high-frequency market indicator that it has become. Economists despair, but it has a market impact. More importantly, from the current relative low, it is poised to make new highs over the next three months. The data is likely to exceed expectations by a margin, helped by the seasonal adjustment process's vagaries, which will weigh the data in relation to last year's 20% annualised decline. Indeed, it is not inconceivable that the second quarter's annualised growth will be similar to last year but in the opposite direction.

The timing of this boost is important for the Fed. Jay Powell is committed to keeping policy accommodative for as long as it takes. The Fed believes that the forthcoming rise in inflation will be the result of transitory, frictional and cyclical factors and that returning the economy to full employment is a greater priority. One quarter of very strong growth should not influence the Fed, but it will impact the treasury market. The Fed has not reacted to the sharp jump in treasury yields over the past month or the curve's substantial steepening because financial conditions have remained highly accommodative.

We owe this focus on financial conditions to the genius of one man, Bill Dudley. Dudley is the unsung hero of global monetary policy, having driven the most important innovation in the 21^st Century. The other, seemingly more noteworthy innovations, such as quantitative easing, negative interest rates, funds for lending, purchases of mortgage and credit bonds, are the inevitable consequences of Bill's inescapable logic. The original measure of financial conditions was developed at Goldman Sachs when Bill was Chief Economist. He then shared this innovation when he was President of the New York Fed, cementing financial conditions at the heart of the Fed's response to the Global Financial Crisis. Dudley's innovation has spawned a range of imitators, many of which contain more components than the five used by the GS index. Still, Bill's index has the longest track record, having been developed in 2000, a year after the ECB's debut in 1999, and the data set has been back-filled to 1960.

The GS US Financial Conditions Index consists of long rates (45.1%), corporate bond spreads (39.6%), trade-weighted US Dollar exchange rate (6%), equity prices (4.9%) and short-term rates (4.4%). In other words, the index assigns the lowest weighting to the instrument traditionally targeted and controlled by the Fed. It is little wonder that the Fed developed new mechanisms to target financial conditions culminating in the program to purchase corporate bonds last Spring. The GS index weighting for corporate bond spreads is eight times larger than the weighting for equities suggesting that an equity market selloff will only be important because it causes corporate spreads to widen. Former Fed Governor Jeremy Stein once noted that what keeps FOMC members awake a night is a 20% widening of corporate bond spreads.

In a valedictory paper in 2018, Dudley's eminent successors, Jan Hatzuis and Jari Stein highlighted that monetary policy's traditional metrics had broken down. Since the failure of the monetary aggregates in the seventies, central banks developed a new Keynesian monetary framework based on the Hicks Investment-Savings Curve, which describes the relationship between the output gap and the real policy rate; a Phillips Curve, which describes the relationship between inflation and the output gap; and a Taylor-type monetary policy rule, which relates the policy rate to deviations of inflation and employment from the central bank targets.

The model is elegant and based on decades of western economic theory; unfortunately, it doesn't work well in practice. It has two flaws; the Phillips curve has flattened over the past few decades and is relatively flat so that it only explains a modest proportion of the variation in US inflation. However, this is not the biggest concern. The explanatory power of the IS curve is also weak, particularly in recent decades. If the Phillips curve fits poorly, the central bank will have trouble controlling inflation but will still be able to control output, but if the IS curve does not work, the central bank will be unable to control either inflation or output.

The authors demonstrate the IS curve's weak explanatory power by regressing the output gap on two of its lags and a measure of the lagged policy rate. They used three separate measures of the lagged policy rate. The first is the real funds rate deflated by the annual inflation rate. The second is the real funds rate minus the estimated equilibrium rate, which uses estimates of the natural R* rate from the work of John Williams, Fed Vice-Chair, and the late, great Thomas Laubach, which in 2018 was 0.6%. The third version is the "narrative approach", developed by Christina and David Romer, which defines monetary policy shocks as the difference between the intended funds rate and the rate implied the by Fed's normal operating procedure. The analysis showed that there was a statistically significant impact from the real funds rate on output, but the significance disappeared when they focussed on the more recent data, and in particular, over the period from 1985, the impulse responses are not significantly different from zero.

The paper justifies the shift from interest rates to financial conditions. We can criticise the shift in terms of the hyper-financialisation of balance sheets, materially higher corporate and government debt, rising inequality, increased portfolio risk and the undermining of defined benefit and defined contribution pension funds, but there can be little doubt that major central banks are explicitly targeting financial conditions. In this world, equities and other risk assets become a policy tool, with asset price inflation leading to easier monetary policy. The rules explicitly forbid the Fed from buying equities, but as last year's crisis showed, in extremis rules are there to be broken. The Bank of Japan, which is further down this process than most, has already crossed this particular Rubicon.

More importantly, in the short-term, central banks are determined to keep financial conditions easy, and despite the recent rise in longer-dated Treasury yields, conditions remain near record accommodation. The Fed doesn't feel the need to respond to these higher yields, risking further rises in the months ahead. Moreover, when the Fed does come to protest the unwarranted deterioration in financial conditions, it will have a choice between Operation Twist, switching the purchase program to longer-dated treasuries or buying corporate bonds to stabilise spreads. In the first instance, the central bank will choose the former.

 

Stuart Thomson is an independent economist and portfolio strategist. His writings reflect his personal views and are intended for the reader's entertainment and to elicit debate. They are not intended to constitute investment advice