Dillian: The Fed’s Slow Moving Policy Error

July 14, 2014

It’s clear the Fed is in no hurry to raise interest rates, and that’s a mistake.

Jared Dillian is the editor and publisher of The Daily Dirtnap, a market newsletter for investment professionals, and the author of “Street Freak: Money and Madness at Lehman Brothers.”

It feels like the markets are at a bit of a crossroad here. Short-term interest rates are rising, the yield curve is flattening, tech stocks have suddenly retreated again, geopolitical tensions are rising and the Fed appears to be on auto-taper.

But there is more than meets the eye. Here’s something people aren’t talking about: The Fed’s monetary policy is currently easier than it has been in many years.

Some of you may be familiar with the Taylor rule. The Taylor rule is a mathematical equation that is supposed to give you the correct, or ideal funds rate. More recently, some modifications were added by Harvard economist Greg Mankiw, and most people now refer to it as the Mankiw rule.

Here’s the thing: Right now, the Mankiw rule says that Fed funds should be at 2.5 percent. As you know, it is at zero percent. And as unemployment inevitably heads lower, and inflation inevitably heads higher, the Mankiw rule will predict that Fed policy will be even more permissive than it is already.

Fed Will Wait For Rate Hike

As you know, the Fed is data dependent with respect to the taper, so if inflation rises appreciably or joblessness improves significantly, the Fed will speed up, right? Unlikely. What’s more likely is that the Fed will taper $10 billion a meeting until the end of asset purchases, at which point it’ll wait something like a year to hike interest rates.

If you recall, Yellen initially said that period of time between tapering and hiking was six months, but the market had a conniption, so she has spent the last few months walking back her comments. Therefore, we’re looking at late 2015 for a rate hike, at the earliest.

But the plot thickens. Inflation is not only picking up (though you won’t read anything about this in the news), but the online, private measures of inflation, like the Billion Prices Project, are picking up quite rapidly. It’s premature to say inflation will become a problem, but it’s definitely worth watching.

It’ll be interesting to see what happens if CPI approaches 3 or 4 percent. Yellen has given every indication that she’ll allow inflation to overshoot, which, going back to the Mankiw rule, will contribute to what I think will be the easiest monetary policy in modern history.

What Does ‘Easy Money’ Mean?

So with this as our base case—that the Fed is overly accommodative—what conclusions can we draw? That asset prices are going higher? I think that’s a little simplistic. Let’s explore further.

As far as economic indicators go, they don’t get much more accurate than the yield curve, whose inversion has predicted seven out of the last seven recessions. It’s a long way from inverting now, but it’s been flattening aggressively, especially in the yield spread between five-year bond and the 30 year-bond.

Here the five-year notes have taken the brunt of the tapering, and the bond is in very short supply due to pension demand (which will probably increase going forward).


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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