The Fed: Higher R* Cometh
Don't be fooled by the Fed's very obvious gaslighting of financial markets designed to manage the rate of ascent in bond yields. R* is going higher.
Discussion
In part 1 of his Jackson Hole preview, Nick Timiraos of the WSJ made it very clear that the Fed’s estimate of the long-term neutral Fed Funds Rate (FFR) - R* as it’s affectionately known - is set to rise. I went through the piece in detail via Xwitter, so I won’t repeat it all here, but the money passage was this:
Every quarter, Fed officials project where rates will settle over the longer run, which is in effect their estimate of neutral. The median estimate declined from 4.25% in 2012 to 2.5% in 2019. After subtracting inflation of 2%, that yielded a real neutral rate (sometimes called “r*” or “r-star”) of 0.5%. In June, the median was still 0.5%.
That also happens to track a widely followed model co-developed by New York Fed President John Williams that also puts neutral at 0.5%.
But while the median hasn’t changed, some officials’ estimates have been creeping up. In June, seven of 17 officials’ estimates were above 0.5% and only three were lower. A year earlier, eight were below 0.5% and two were above.
This is signaling to the market that R* is going higher. But to those paying attention, this is hardly news.
The Fed first starting communicating that R* is headed higher via former FRB New York President Bill Dudley back in June via Bloomberg op-ed; last week Larry Summers said that UST 10s are likely to average 475 bps over the next decade (in line with Dudley’s 450 estimate); and then just this morning Dudley came out again reiterating a higher R*:
“…the economy’s strength amid much higher interest rates suggests that the neutral rate is higher than previously believed. This is starting to seep into Fed officials’ forecasts: In the June Summary of Economic Projections, the central tendency for the long-term federal funds rate moved up slightly. I expect officials to keep revising their estimates of r* upwards, though this probably won’t be reflected in estimates based on econometric models, which are slow moving and somewhat skewed by pandemic-period data.”
Despite the overwhelming weight of the FED communication evidence pointing to a higher R*, yesterday and today doubt began to seep into the market narrative. First, in response to this xweet from Julia Coronado…
…Timiraos xweeted the following, directly contradicting the principal thrust of his part 1 Jackson Hole preview piece:
Then fast forward to today, close FED contact ISI wrote the following to clients:
Markets have been on edge heading into Fed chair Powell’s speech at Jackson Hole Friday.
There is concern he could endorse the idea stronger-than-expected growth today means the neutral rate r* is likely to be higher in the longer run too and the era of structurally low rates is over - a signal that would supercharge the move up in bond yields and drive equities lower.
We think this is overdone. We think Powell will focus on the short to medium term outlook and avoid making a call on r*.
Notice the subtlety in what ISI said. Powell can avoid “making a call on r*” while keeping the door wide open to R* moving higher in the September SEP as FED communication since June has strongly suggested.
Don’t be fooled by this very obvious gaslighting ploy by the Fed. They are in the business of managing volatility, and they do not want an out-sized, rapid tightening of financial conditions in the lead-up to Powell’s speech on Friday where he is very obviously going to swing the door wide open to a higher R*.
Gaslighting Precedent
The most recent example of this gaslighting ploy was around Powell’s March 7-8 Congressional testimony. On the first day of testimony Powell opened the door to going back to 50s starting with the March FOMC meeting. UST 2s responded to the remarks, closing near the highs of the day at 501 bps versus a prior day close of 489 as market participants raced to price in a higher probability of the Fed hiking by 50 later that month.
Clearly disturbed by the out-sized one-day move in rates, Powell added a line to his opening remarks the following day saying “no decision had been made” about the March meeting. UST 2s responded to the shift in language by initially dropping to 497, but then ended up going out at the highs of the day at 507 bps.
Powell knew full well the Fed was going to hike 50 in March, but he wanted to smooth out the ride there. We all know what happened just 48 hours after he finished his testimony, but as confirmed by his remarks in later press conferences, it is very clear they would have hiked by 50 in March had SVB not collapsed.
As discussed yesterday, Julian Brigden’s policy contacts confirm the Fed is worried about an economic reacceleration, which explains why the Fed has allowed such an out-sized move in rates to occur since mid-July.
Powell’s speech at Jackson Hole on Friday will swing the door wide open to a higher R*, officially rubber-stamping the move in rates. Don’t be fooled by the Fed’s gaslighting ploy to manage the move higher.