One of the first rules of riding a bicycle is to ‘”shift gears early and often.”
This constant adjustment keeps up momentum without wearing out the rider or the bike.
Ideally, any Fed Governor would follow this same course of action; but like competing in the Tour de France, it’s far from easy.
To “shift early” is to be prepared for what’s on the path ahead, rather than scrambling to shift on rough terrain. Shifting gears in the face of ascent or descent makes for weak legs and no time to adapt.
Even worse, if the gears don’t adjust seamlessly, the entire bike is compromised – the chain will be misaligned, throwing it off the sprocket, and potentially throwing the rider from the bike.
Thus, to “shift often” is to fully engage with the bicycle and its mechanics to achieve maximum performance.
As Chair of the Federal Reserve Bank, Janet Yellen and every one of her predecessors have had to learn to “shift gears often and early” in the constant race of the market. Each day requires a hard look at the path ahead and a decision of whether to stay the course or shift gears.
Whether it’s an uphill climb or a downhill battle, the bicycle is driving monetary policy and the tools are the gears, or interest rates – namely, the Fed Funds rate.
Starting in Low Gear
Yellen, however, seems to be struggling to time her shifts in accordance with market predictions.
On February 1, 2014, the first day of Yellen’s term as Chair, the Fed was still recovering from the financial crisis of 2008 under Ben Bernanke. But there are only so many gears between a steady decline and first speed, and only so many basis points you can lower before you get to zero interest rates.
Each of Bernanke’s interest rate reductions had less of an impact than the previous one, and toward the end of his term it was as if he were on a stationary bike – peddling in place.
While it’s debatable whether or not Yellen shifted early, with a 25 basis point hike this past December from near zero, she certainly isn’t shifting often.
At the time of the hike, the Fed indicated that it expected four rate hikes in 2016. Despite repeated claims of increasing rates, instead of shifting gears up, the Fed is backpedaling. In fact, last week it forecast a rate of 1.6% next year and 2.4% in 2018, both decreased projections from March rate levels.
This week, Yellen’s tone and stance have remained largely unchanged. During her testimony, she signaled more caution on the economic outlook as optimism has softened.
From Hands on the Brakes to Road Rash
When a cyclist sees an incline in the distance, it might not be clear just how close or far the challenge is, or how steep or long, but one thing is certain – it’s time to pedal harder and faster.
Similarly, when the economy needs the momentum to make it uphill, that push is stimulus. Bernanke, for instance, used quantitative easing (QE) to get over the mountain that was the financial crisis.
And like most bumpy terrain, it was difficult to determine exactly when the descent would begin, or how steep it would be. Furthermore, a cyclist must stay on high alert for sharp turns or changes in the environment or the road’s surface. Consider those potholes that appear out of nowhere, as well as the occasional deer in the road.
There’s much that can’t be foreseen, no matter how often a cyclist switches gears. Thus, like in monetary policy, breaks are an absolute necessity to prevent the disaster of popping a tire (a bubble bursting) or going head first into a tree (an economic crash).
All of these unanticipated obstacles can result in a disaster without proper action.
Consider the 1997 enactment of the Tax Payer Relief Act as that sharp curve resulting in the 2000 bursting of the dot-com bubble.
Then, in 2007, the aggressive selling of CMOs was a major pothole that resulted in the financial market crash and a real estate bubble burst the following year.
And the advancement of hydraulic fracking that caused a 2015 crash in oil and energy prices (and eventually the commodity sector as a whole) was that deer in the road.
The New Abnormal
Today’s markets are experiencing what we could call the new abnormal – yield curves are flat, unemployment is at 4.7%, and there is zero inflation. On June 13, the yield on the 10-year Treasury traded at 1.57%.
Bottom line – it’s a new world and we weren’t ready for it.
In his position paper, St. Louis Fed President James Bullard, one of the Fed’s most aggressive rate hawks, stated: “An older narrative that the bank has been using since the financial crisis ended has now likely outlived its usefulness, and so it is being replaced by a new narrative. The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes.”
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With inflation quiescent around the world, bond yields have fallen below zero in some places. And while yields on sovereign European notes of shorter maturities have been negative in places, for the first time in history the yield on the 10-year German bond went negative Tuesday.
Meanwhile, developed market banks are unwilling to lend or to take risks.
Arthur Burns, Master Cyclist
The Fed, since 1977, has been guided by its dual mandate of maximum employment and moderate long-term interest rates.
Perhaps, therefore, an Arthur Burns-style abrupt policy change could be the answer. Burns surely could have been a cycling instructor, shifting early and often.
As the Fed Chairman from 1970-1978, Burns had a reputation of being overly influenced by political pressure in his monetary policy decisions and for supporting policy that was too eagerly accepted in political and economic circles.
During his tenure, the rate of change of the CPI rose from 6% a year in early 1970 to over 12% a year in late 1974 (post Arab Oil embargo), and eventually falling to under 7% a year from 1976 to the end of his tenure in January of 1978.
Burns prescribed to the Phillips curve, an economic concept developed by A. W. Phillips. This concept shows that inflation and unemployment have a stable and inverse relationship, in that economic growth leads to inflation, which in turn should lead to more jobs and lower unemployment.
Unfortunately, today’s economy is proof that the Phillips curve doesn’t always work.
Back in the Saddle
Jim Bullard said it best: “The mismatch between Fed and investor expectations for the fed funds rate is eroding the central bank’s credibility and causing distortions in the market.”
So, does the Fed need a $75,000 Trek Madone 7- Diamond bicycle or a basic single-speed?
Yellen has become tacit and exceedingly cautious about changing rates, so much so that anticipation of a mere 25 basis point move in the Fed funds rate wreaks havoc on global markets.
And once the Fed makes a move – in either direction – it signals to the markets that it’s on a path of ongoing shifts in that same direction.
The Fed wants to maintain constant cadence, despite changes in resistance or incline on the road. It wants to shift gears smoothly rather than endure the grinding of gears, the same noise creating volatility in the markets. To change gears is to admit error or the inability to anticipate the road ahead.
Recently, Bullard actually made a significant shift in his outlook for the economy – now predicting that low growth and a very low Fed funds rate of just 63 basis points will likely remain in place through 2018. The current target rate is 25 to 50 basis points.
The Fed’s so-called “dot plot,” which depicts Fed officials anticipated interest rates, shows that one official saw just one interest rate increase through 2018. We now know that this dot represents Bullard.
The Fed, no doubt, faces some difficult choices – policies have led to imbalances that result in pressure to raise rates.
Central bank leaders need to take on the body politic, and maintain an inflation target.
Yellen, however, has little to say about bubble risk. But it’s time to address the inequality in wealth and income as a result of QE. QE has also contributed to extraordinarily low yields in the bond market, helping create a surge in American household wealth that has outstripped growth in wages and income.
And as low interest rates increase bond values, they make other investments more appealing from a relative standpoint, including equities and real estate as well as art.
Not all households can invest in these alternatives, meaning that the surge in wealth is concentrated, and isn’t reflected in spending. We need a zero to negative rate transmission mechanism down to individuals, small businesses, and even municipalities, as these low rates aren’t doing enough to encourage spending. Instead, potential investors and simply paying down debt.
The risks facing the still fragile domestic economy loom large, but according to Yellen, the case for holding rates steady is simple. This week her message conveyed that the Fed is deciding whether, not when, to raise rates.
So for the time being, she’ll keep the rubber on the road, on a single-speed bike – let’s just hope there aren’t any obstacles in sight.