Tag Archives: macro

What’s that lever over there marked “rates” do?

Although the FOMC’s discussion of slowing or ending its Large Scale Asset Purchase (LSAP) program have induced a collective fear of a rapid pace of tightening and rate increases, leading to a steeper yield curve, it is important in moments like this to remember exactly how monetary policy works. At the present time, the Fed primarily relying on two tools to handle monetary policy: rate policy and quantitative policy. It uses these two tools to achieve its dual mandate of price stability (currently defined as a 2% symmetrical inflation target as measured by the core personal consumption expenditures deflator) and full employment. At the time of this writing, rate volatility appears to have been triggered by discussions of pulling back on the quantitative throttle by slowing the rate at which the Fed increases the size of their balance sheet. That is reducing the rate at which the Fed is easing, not tightening, although one has to wonder if, in en environment that shrugs off $85B of monthly easing, less easing than expected becomes de facto tightening.

Rate policy is primarily used as a tool to disincentivise borrowing by making it more expensive. Traditionally this was done by changing the Fed Funds target rate. Assuming a negatively sloped demand curve for loans, a higher rate of interest will reduce the quantity of loans demanded and reduce the money created by money multiplication (monetary inflation) in the banking system by limiting velocity. Ultimately, this leads to a decrease in credit-driven Consumption and/or Investment, which puts downward pressure on inflation. Until 5 years ago, FF rate targeting was primarily achieved through a mix of Open Marker Operations and changes to the discount window rate, setting a ceiling or upper bound on the Effective FF rate. In October 3, 2008 the Fed started using a new tool, Interest on Excess Reserves to (IOER), to effectively put a floor on Effective Fed Funds, the success of which has been mixed, at best.

YoY % Credit Growth

Figure 1: YoY % Credit Growth

Therefore, in order for rate increases to be necessary, inflation must approach or exceed the symmetrical target of 2% during a period of close-to or full employment. In contrast to prior cycles, the Fed has “guided” market participants as to the meaning of these measures by disclosing what is colloquially referred to as the “Evan’s Rule,” a threshold (not a trigger) which suggests unemployment to fall below 6.5% and the 2% symmetrical target to be met or breached before the target FF rate is increased.

YoY % Core PCE Price Change

Figure 2: YoY % Core PCE Price Change

Given that core PCE inflation is significantly below its symmetrical target of 2% (Figure 2), unemployment remains elevated and employment growth tepid, and annualized nominal GDP growth has decelerated since Q1 2012 and is has barely registered 3.1% for 3 consecutive quarters, we believe the risk of rapid rate increases in the near future is very low absent a very sudden and very sharp increase in demand for credit-driven Consumption or Investment.

YoY % GDP Growth

Figure 3: YoY % GDP Growth

We are not doomsayers, but it is important for participants to understand how rate policy works and why it is used. While the hand-off from quantitative policy to rate policy is a prerequisite of any change in the FF target rate (quantity or price but not both), it provides us no clue as to when this change will take place. In other words, the role of LSAPs as a signaling tool for rate policy is limited to letting us know when the rate regime has been begun again, not when it will be mobilized. Until we face loan demand that is high enough to fuel an accelerating expansion of the money supply, not only will the rate lever remain unengaged, but there will be no credible risk to price stability to warrant the use of it--we could be at the zero-bound for a long, long time.

Figure 4: KTF Neutral Policy Rate

Figure 4: KTF Neutral Policy Rate

Additionally, from the quantitative angle, many market participants claim that any rate increases will be impossible while the system remains flooded with reserves and starved of collateral, exemplified by the FF-IOER spread and GC-IOER spread or the house favorite here at Contrarian Corner, the KTF Neutral Policy Rate Rule (Figure 4), which despite talks of impeding taper keeps showing the neutral policy rate at new lifetime lows week after week (and, recently, into the uncharted waters of negative nominal rates). Many participants with expertise far beyond mine have opined that, with IOER failing to act as a credible floor, rate increases are actually impossible until reserve pumping not only stops, but a large quantity are mopped op or the size of the economy grows into the new and much-expanded monetary base. Sensei KTF would pose the question, "how many CBs have ever exited?" (spoiler alert: none) however, if the mopping of reserves was ever to become necessary in anticipation for a rate-increase, any credible attempt would begin with the Fed's latest gender-bender toy, the Full Allocation Fixed Rate Reverse Repo Facility (FAFRRRF, or "Death Star" to the initiated), which promises to to provide the invisible floor IOER failed to and bridge us as we take the leap of faith across the impassable ravine from quantity to price. I don't know about you, but I'll have my chalice filled with whiskey, if you don't mind.

Interpreting Very Scary Macro Charts

Earlier today, Fund Manager and well-known weekly market comment author John P Hussman posted the following chart on a tweet, illustrating the exponential decay of the short term interest rate as the Fed's balance sheet grew with respect to nominal GDP:


My first reaction was one of shock, particularly because the last 3 days of rates increasing have been painful enough as it is! There seems to be a very clear trend here that makes for a Very Scary Macro Chart. However, let's try to digest this calmly. The "You are here," arrow points to a place that looks to correspond to a 0.20 ratio of MB to NGDP. Loosely following the sample path leads us to believe that the area between 0.08 and 0.10 is home to the 2% 3m bill rate. Considering the below-target level of inflation and Chairman Bernanke's wording about not selling assets, we can conclude that, in the near-term, it would have to be an increase in NGDP that led to those higher 3m rates. Using the 0.1 barrier for the sake of simplicity, it would roughly mean NGDP doubling. To gauge the true scariness of Dr Hussman's chart, we could look at forward rates and find when the yield curve is pricing in a 2% 3m bill. Lucky for us, the Eurodollar curve provides a fast and easy way to find this out. Assuming a 15bp FF-LIBOR spread, a 2.15% 3-m LIBOR is being priced somewhere between June and September 2016 (EDM6, EDU6). Assuming no further changes to the Fed's balance sheet (although, as he indicated, more growth is planned and currently happening) it would take an annualized increase in NGDP of ~26% to get to a MB/NGDP ratio that justifies the current forward curve's pricing of a 2% 3m bill 3 years from now.

What's the interpretation? Well, it appears that the Very Scary Macro Chart would indicate that balance sheet expansion is way too dovish and that rates are too damn high, making eay for a flatter, lower yield curve; a high level of NGDP growth; and a shrinking Fed Balance sheet to be able to peacefully coexist. If that is the case, we would consider Mr Hussman to be much more of a bright-eyed, bushy-tailed optimist than he sometimes lets on.