The financial lift-off

This week, the Federal Reserve raised the main policy interest rate from essentially 0% to 0.25%, which ended an era of zero interest rate policy ("ZIRP") in the United States. There already appears to be a name for this event: the lift-off, presumably meant to evoke images of a launching rocket and strong economic growth.

My first perspective is always from high above. The Federal Reserve aims for a 2% inflation rate over the medium term. To accomplish that they implement monetary policies, such as trying to enforce the Fed Funds rate. So, let us look at the US inflation rates over the last years.

The central bank does not use the consumer price index (CPI) directly for guidance, as it is deemed too volatile and too sensitive to food and energy prices. Instead, their preferred measure is the price index for personal consumption expenditures (PCE), excluding food and energy. Evidently, neither the CPI, nor the core-PCE has been above 2.0% since 2012, indicating that the Fed is having troubles implementing their policy, and to make matters worse, the CPI started plummeting in the end of 2014, as a result of the crash in commodity prices, and it is now hovering around 0%. Fortunately for the Fed, the core-PCE remains stable around 1.3%, but it is still far below the 2.0% target. So a priori, one can question why the Fed is raising rates now and shifting into a more restrictive monetary policy. The data does not seem to really support it, even though the Fed is always very keen on being "data dependent". In that perspective, the move by the Fed is rather hawkish and the question must be asked whether it is a preemptive move to stave off future bouts of inflation.

I think that the key to the conundrum is to take the view that the Fed does not actually control the short-term interest rates directly (or the real economy, for that matter). In theory, a sufficiently determined and powerful central bank can always print money at will and thus create inflation, but in practice, they cannot. Instead, they have to adapt the monetary policy to reflect the underlying economy, such as the short-term rates determined by market, which by themselves are dependent on the current expected return on investments. Former Fed chairman Ben Bernanke (perhaps speaking more freely now?), alludes to this in his essay Why are interest rates so low?:

The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.

I think last years developments in the US treasury market is a proof of this statement. As a bellwether of changes in the short-term interest rates, I like to look at the 13 week Treasury bills index (IRX):

Short-term market rates started moving up to 0.2% ahead of the December 15-16 meeting, so there was no question of a raise being necessary to keep in sync with the markets. Ahead of the previous FOMC meetings during 2015, there were no such moves. The market rates did make a move for 0.1% in the August timeframe, but they fell back, which prompted the Fed to hold the rate hike. In addition, long interests rates, such as the 10-year rates (TNX) did not move much, the big move happened in the beginning of the year, when it became clear that the US was about to exit the ZIRP policy.

My interpretation, when looking at the IRX rates, is that it is not a natural rise as a result of underlying growth in the economy, but rather a reflection of the Fed's signaling. The Fed is trying to indirectly force rates up, "jawboning" to speak the market lingo. It is important to remember that a central theme in modern central banking is management of inflation expectations, rather than outright control of the markets. Their main tool nowadays is, so to say, to manage the animal spirits, which is not unlike being in the advertising business. I think that is why they announced the four-stage hike in advance, to try to force the short rates upward, via a self-fulfilling cycle. The indications so far from the markets are that it might work, although just temporarily, if we are to believe Bernanke per above. But in the long run, there has to be economic growth to support it.

I too think it can work, if there is no stock market crash, which would greatly increase liquidity and increase the appetite for government bonds of shorter duration. A firm belief in the strength of the US economy can likely keep it afloat for 1-2 years more, over the presidential election, but the result is likely a flattening of the yield curve, which will gradually appear as the business cycle turns down. Thoughts along this direction represent very much the mainstream view of the market forecasters nowadays, which is that the US will hum along faster than many other parts of the world for a few years, but that a recession eventually will have to come. The way I see it happening is through heavy investments in energy infrastructure driven by environmental concerns and low commodity prices initially, but these activities will be hitting a brick wall once commodity shortages become apparent, as a result of the severe cutbacks in production capacity during 2015 and 2016. Perhaps this is why the Fed is choosing to be preemptive in fighting inflation. In a few years, commodity prices might again rise sharply, which combined with some actual economic growth could ignite inflationary pressures.

In the long term, though, interest rates are likely to stay low. There are structural reasons for the low growth in the US and Europe, such as demographics, the high debt levels, the need to upgrade energy infrastructure, and the diminishing improvements on productivity as a result of new technology. These trends tell me that we are unlikely to see a change in the slowing of economic growth, which has been a 50+ year long trend. I would be surprised if the economic growth rate surpassed 2-3%, which also means that I would be equally surprised to see the Fed aim for a policy rate above say 2% in the coming years.