Discussion
It’s too late for a full analysis, so I just want to get my Q&A notes and some initial thoughts down. I’ll have a fuller write-up later once I absorb the messages from what I think was a pretty pivotal appearance by FED Chair Powell.
He repeatedly went out of his way to mention strong demand
He mentioned the outlook for interest rates “in five years” at least twice, likely IMO to extend the time horizon for restrictive rate policy
Clearly he is pleased with the long-end-driven tightening in FCI, borderline joyous about it, at one point joking about his “priors” being confirmed by the rise in rates
He went out of his way to dismiss the impact of higher rates on small businesses and focus his answer on the critical need to get inflation back to 2%
He mentioned FCI tightening not happening as fast as the Fed would like
Lastly, he went out of his way to say that FED independence is critical for times like now when the Fed needs to do something unpopular like bringing down inflation
Q&A Notes
Economic Resilience
Resilient economy on our hands
Growth running above longer run trend driven by consumer spending and a strong job market
Really is a story of much stronger demand
Economy may be less affected by interest rates. Corporate bond issuers have termed out debt, as have low-rate mortgage holders
Rates just may not have been high enough for long enough
It’s all happening in the context of very strong demand
Terming out of Debt
Rates are having the typical impact where you expect to see
“Again, it goes back to just very strong demand.”
We take the economy the way it comes. The fact we have a strong economy, a strong job market, and inflation coming down, these are the elements we want to see to achieve the outcome we want. It may take more time, but this is what you want to see to get through this without a big increase in unemployment.
Long and Variable Lags
Asset prices, interest sensitive spending, and the exchange rate
We do see that happening, just not as fast as we would like as a result of stronger demand - household savings and spending
Neutral Rate
Looking at notes… “Hard to be confident what that will be in five years.”
Before the low inflation period a typical FED tightening cycle would end with rates at 5-6% and settle out at 4-5%
With emphasis: The ZLB is no longer an issue. Very far from the ZLB and the economy is handling it just fine due to very strong demand.
Hard to know what the economy will want for interest rates five years from now once all the effects of the pandemic have washed through the system
R-Star
“We’re finding it.” It being R* and the neutral rate, which he conflated a bit in the answer
The economy is handling rates just fine, either because the neutral rate has risen or rates have not been high enough for long enough
“Policy is not too tight right now.”
What does the economy look like post-pandemic inflation problem?
Some have argued the last 25 years were a perfect storm of disinflation and now we’re going into a period of higher inflation characterized by more frequent supply shocks
None of this matters. We’re looking to reach a sufficiently restrictive level to bring inflation down to 2% over time
The Long End
Not about higher inflation expectations
Not about expectations of higher Fed Funds as evidenced by limited movement in 2s
Really due to term premium
Other factors
Economic strength
Fiscal deficits
QT
Stock-bond correlation. In a higher inflation world bonds aren’t a good hedge thus a higher term premium is required
Persistent changes in FCI impact the economy.
Is FCI tightening because the market expects the Fed to take further action, in which case the Fed would need to follow through? But that doesn’t seem to be the case, as it seems to be the result of mostly the other factors
Private Sector Cost of Capital
CEOs saying economy is strong
Consumer is strong, as evidenced by retail sales
Small businesses are impacted by higher rates
But the world counts on us to deliver low inflation despite the negative effects of our blunt tools
“Our independence is not for times when we’re really popular. It’s for when we’re doing something that the public counts on us to do.”
FCI Tightening
As long as rate are going up for reasons other than the bond market expecting the Fed to raise rates further, that’s a good tightening of FCI. Otherwise, if the Fed doesn’t hike they come right back down
This FCI tightening is exactly what we’re trying to achieve
FCI tightening could substitute for more hikes, but that remains to be seen