Dillian: The Fed’s Slow Moving Policy Error

July 14, 2014

Investors should be alarmed at the rate of curve flattening. But it seems nobody is talking about it outside of a few macro portfolio managers and dedicated market watchers like me.

The other indicator to watch is the yield spread between two-year Treasury notes and Fed fund rates. When two-year yields are well above the Fed fund rates, it means the market is pricing in Fed tightening. When it gets to about 1 percent above the Fed fund rates, it tends to be a pretty reliable indicator of market stress.

The Fed may control the overnight rate, but it doesn’t control two-year Treasurys or eurodollar futures. The short-term interest-rate market is quite large and has the ability to do the Fed’s job if the Fed gets lazy.

Markets Will Push The Slow Fed

More succinctly, the greatest risk to asset markets presently is the likelihood that the Fed will move too slowly and markets will tighten for it. That was the genius of Alan Greenspan—the market would price in Fed action, and it was rare that the Greenspan Fed ever deviated from it.

Either way, the tightening is coming, whether the Fed does it or the market does it.

Tapering has caused a negligible amount of turmoil, unless you consider the massive backup in rates when it was first discussed in May 2013. The Fed has done a yeoman’s work at tapering asset purchases with a minimal amount of market stress. But raising interest rates, after they have been at zero for fix years, will be a different story.

Fed Will Have To Tighten

And yet, unemployment goes lower and inflation goes higher, and a rule-based Fed would have a heck of a time not raising rates at this point.

What’s going to happen on the next unemployment report if it comes in under 6 percent? What if the unemployment rate gets to the Yellen’s magic 5.5 percent number well before the rate hike in late 2015? Will Yellen walk the rate hike back even further, using the discouraged-workers argument?

The last time the Mankiw rule was screaming that the Fed should be raising rates was in 2002 and 2003, when we had a policy error of a different sort: the Fed grossly overestimated the severity of the 2001 recession and lowered interest rates to 1 percent and kept them there for too long. The unintended consequence? The housing bubble, and subsequently, the financial crisis. The Fed exacerbated the boom/bust cycle instead of attenuating it.

So what unintended consequences will arise from this policy error? Inflation, probably. Not only are the online measures of inflation starting to run, but commodities and commodity stocks have woken up from a deep sleep, another trigger for inflation.

I offer no predictions, except that the market will probably go from somnolent to turbulent. And the Fed’s policy error will persist. This will make some people happy, others not so much.



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