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Sunday, May 1, 2016

The Fed And Übergradualism

The Fed has done a good job of painting itself into a corner. Financial market participants have worked themselves up into a hypersensitive mood with regards to central bank actions, even though there is little evidence that the economy itself is sensitive to small changes in monetary policy. About the only palatable way out is for the Fed to give in and follow a policy of  übergradualism -- hiking rates by 25 basis points at every second meeting.

Fed Watching

Although I am in the camp that insists that the medium-term outlook for the policy rate is the major determinant of bond yields, I do not think that it is a good use of resources to spend too much time attempting to decipher the current thinking of policy makers ("Fedwatching"). The key is the qualifier "medium term"; what the Fed does at the next meeting or two does not really matter for anything other than money market instruments.

Policy makers do not set the interest rate on long duration instruments, and so they have the luxury of being able to change their mind at any meeting. Investors are not so lucky; if you are trading a 10-year instrument, your fundamental thesis will only be validated over the next ten years. Correspondingly, attempting to replicate how central bankers think is likely to be costly, as you cannot afford to change your view too many times as a result of new data.

As a result, it is best to outsource central bank watching to others. I generally keep track of Tim Duy's analysis, as I believe that he is one of the best "Fed watchers" who publishes in the public domain. His latest article, "Warning: Hawkishness Ahead" gives an overview as to why the markets may be too complacent about rate hikes this year.

The Case For Übergradualism

I do not agree with everything Tim Duy writes; our theoretical beliefs are dissimilar. However, I believe that he is correct in assessing that the Federal Open Market Committee would like to hike rates.

The last thing that Fed policy makers want is to head into a recession with the overnight rate at less than 1%. However, if they hike rates by 25 basis points per year, that is exactly what will happen, barring some miracle extending this business cycle's lifetime.

Chart: 2004 Rate Hike Cycle

The policy of the previous cycle -- hiking by 25 basis points a meeting -- was known as gradualism. The chart above shows the regularity of the rise of the Fed Funds rate. Although this was criticised as being too slow, and somehow causing the Financial Crisis, such a pace of rate hikes (200 basis points a year) could spook financial markets. Given the tepid nature of economic growth this cycle, it is unclear that the Fed would need to raise rates at such a pace.

About the only clean way forward is to hike by 25 basis points every second meeting, for a cumulative increase of 100 basis points a year ("übergradualism").

Although some were unhappy by the mechanical nature of rate hikes in the last cycle, the alternatives are worse. If the Fed attempted to make rate hikes irregular, they would either have to revive 12.5 basis point increments (1/8 %) or else risk causing a panic. An irregular pattern of rate hikes would eventually require rate hikes at back-to-back meetings. That might appear to be a signal for a more rapid pace of hikes, which could easily destabilise markets.

Should The Fed Be Hiking?

I have not addressed the issue of whether the Fed should hike rates. I think that the effects would be mixed; rate hikes would be a signal that the U.S. economy was in a strong position, and might help business confidence. Furthermore, higher interest rates create income flow effects that might help aggregate demand -- the corporate sector is a net borrower, and has been tending to hoard cash (or just inject the cash into the equity market via buybacks).

Otherwise, the economy is not particularly sensitive to interest rates. It would be hard to be concerned about a policy that only changes rates by 100 basis points a year.

(c) Brian Romanchuk 2016

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