New directions for the Fed in 2015

The big decision for the Fed next year will be if they should start raising interest rates. Remember that the fed is charged to try to maintain price stability and full employment. This chart shows unemployment and inflation along with the Fed’s inflation target (in blue) and the unemployment rate consistent with stable prices (in pink). The economy has improved without inflation over the last five years.

phillips.pce-2014-11-14

The argument for raising rates is that it is necessary to control inflation.  This this post from The Economist for example.  I disagree for a few reasons:

  • As the chart below shows, over the last 20 years actual inflation has spent a good deal of time below a band around 2% inflation except and only brief episodes above, suggesting that the Fed is too hawkish on average.

inflation

  • There is mounting evidence (for example this note published by the Fed) that the recessions, the possible outcome for raising rates prematurely, can involve permanent reductions in the level of output. Simply put, if you have a million people working for a year they make a certain amount of stuff. If there is a recession and they are out of work, they don’t make up all of the lost output once the economy recovers. To take this risk the threat to price stability must be substantial.
  • Finally, inflation expectations (based on surveys or derived from market prices) remain stable.

Of course, what I think doesn’t matter, only the opinions of the voting members of the FOMC count. Every year a shifting cast of regional presidents serve as voting members on the FOMC. This year sees 4 new presidents along with the chair of the NY Fed who is always a voting member in deference to that bank’s constant connection with the markets. We have two members I would characterize as patient about raising rates and two who seem eager

  • Richmond Fed’s Jeffrey Lacker says that “the unemployment rate is an accurate gauge of labor underutilization. ” Suggesting that rates can rise soon.       Interestingly, he not only expects to raise rates, he wants the Fed to sell securities held under quantitative easing, not just cease to purchase. “I believe the Fed’s efforts to normalize monetary policy must include the sale of mortgage-backed securities in order to reduce the Fed’s role in credit allocation. ” Lacker speech
  • Similarly, the San Francisco Fed’s Williams says “Rate hike likely by mid-2015” Williams speech
  • On the other hand Chicago’s Charles Evans sees risks to tightening: “I am concerned about the possibility that inflation will not return to our 2 percent PCE target within a reasonable period of time.” And he emphasizes caution: “As I think about the process of normalizing policy, I conclude that today’s risk-management calculus says we should err on the side of patience in removing highly accommodative policy.” Evans speech
  • At the Federal Reserve bank of Atlanta Dennis Lockhart believes the United States will approach conditions consistent with full employment by late 2016 or early 2017 and in his view undershoot of the inflation target is currently a bigger risk than overshoot. Lockhart speech
  • The New York Fed president William Dudley seems to be willing but not eager to raise rates next year: “The consensus view is that lift-off will take place around the middle of next year.  That seems like a reasonable view to me.   But, again, it is just a forecast.  What we do will depend on the flow of economic news and how that affects the economic outlook” Dudley speech

Incidentally, NY Fed President Dudley says

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures.  Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored.  However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis.  Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk.  Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

If he is using this as a reason to raise rates, I cannot agree. First of all, surely a decline in inflation risk premiums means that the market is less concerned about sudden jumps in inflation. That is, the market is telling you that the market is not worried about inflation. I am not sure why a policymaker would want to discount that. Second, it is not clear that Survey based inflation expectations are indeed stable. See this chart of expectations for next year from the Consensus Economics survey.

cpifc

Whatever is ahead, our next landmark is the final FOMC meeting of 2014 which will feature new forecasts from the committee members and a Janet Yellen press conference on December 17. Hopefully we will get more insight into the Fed’s plans then. In the meantime it is worth noting that for Fed Funds to get to what the median member expects of about 1% by the end of 2015 and they proceed in bite-sized 0.25% steps, they will need to start raising rates in their fifth meeting of the year in July. Given the Fed’s reluctance to surprise the markets, I would expect clear warnings at the March press conference at the latest.

Interestingly, the Fed Fund futures seem to expect less easing overall with year-end 2015 rates in the market at 0.5% which implies starting later or not raising rates at every meeting after they start.

Don’t Panic

The recent stock sell-off certainly has our attention. Yesterday, October 14th, the S&P 500 closed about 6.6% off its high, set only a month ago. And writing before the opening of October 15th, it looks like another bad day. As always, there is a chance of a further stock market decline, but we think the risk reward proposition of the stock market is still favorable. Accordingly. we have not reduced our exposure to stocks yet, though we are monitoring the situation closely. Why might investors want to cut their positions and why hasn’t Astor?

The fundamental argument for panicking

The strongest fundamental argument for reducing equity exposure is the possibility of a renewed recession in Europe, perhaps leading to deflationary fears in the developed markets. Recent news in Germany in particular has been disappointing, and any growth in the periphery is coming off of a very low base. We started noting weakness in the Eurozone in July, with our latest update last month here. In the last few months, the ECB has raised and disappointed expectations for a dramatic non-traditional easing. A renewed recession Europe would reduce growth prospects in the US somewhat and may have an outsized impact on large cap stocks which generate a good deal of their profits outside the US.

The “fear itself” argument for panicking

Roosevelt said, “The only thing we have to fear is fear itself.” Similarly, the sell-off in stocks itself (and the rise in the VIX, part of the same phenomena) is its own reason to cut positions. While we do understand the inclination, and we think a sober, quantitative risk control framework is important, we are not so sure that just cutting stocks because they are going down in price is always the best method. In fact, if you stayed out of the stock market every month which started with a 5% of greater drawdown you would cut your compounded annual growth rate by half over the period of 1970 – 2014. You would have to be a fearful investor indeed to be able to sacrifice half your returns.

Note that not all of the decline in the price of risky assets (such as stocks and commodities) is bad news. The decline in the price of oil, if translated into its typical relationship to retail gasoline prices could translate to a $600 per family bonus. A little stimulus at just the right time.

The stronger argument for staying the course

At Astor, the current state of the US economy is the primary input into determining the optimal mix of stocks and bonds. As far as we can see today, the state of the US economy is strong. We see it in the strength of the labor market and the strong pipeline for manufacturing. If the economy begins to slide, we will adjust positions. It is possible the current stock market weakness foretells a recession, but in general using the stock market to predict recessions is a losing bet.

In addition to the real economy, we closely monitor the level of a much broader collection of indicators which measure financial stress. The well-known VIX is included in this mix, but so are several other measures. We collect these indicators into a daily index of financial stress. So far, this measure has not risen to the levels where evidence has suggested reducing exposure.

Our conclusion: Don’t Panic

Because of its association with outsized declines, it is uncomfortable to write in October that we expect today’s stock declines to be transitory, as a gut reaction says to head for the hills. Our research counsels a steady hand, however, and as long as the fundamentals do nott change, we will not either.