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Fed’s R-Star Is A Black Hole

Summary:
President Donald Trump must regret that he didn’t renew Janet Yellen’s contract to head the Fed for another four years. She probably would have been more accommodating to his supply-side policies. They both are populist do-gooders at heart. They want as many people to get jobs as possible. Instead, Trump appointed Jerome Powell to be the new Fed chairman at the start of this year. Powell had been the vice chairman under Yellen. Trump appointed Richard H. Clarida to fill Powell’s vacant position after he was promoted. Both Powell and Clarida are all for continuing to raise interest rates. Both see strong economic growth and a tight labor market as potentially inflationary. So they want to raise interest rates to avert this scenario, by slowing the economy down. No wonder that the 10/23

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Fed’s R-Star Is A Black Hole
President Donald Trump must regret that he didn’t renew Janet Yellen’s contract to head the Fed for another four years. She probably would have been more accommodating to his supply-side policies. They both are populist do-gooders at heart. They want as many people to get jobs as possible.

Instead, Trump appointed Jerome Powell to be the new Fed chairman at the start of this year. Powell had been the vice chairman under Yellen. Trump appointed Richard H. Clarida to fill Powell’s vacant position after he was promoted. Both Powell and Clarida are all for continuing to raise interest rates. Both see strong economic growth and a tight labor market as potentially inflationary. So they want to raise interest rates to avert this scenario, by slowing the economy down.

No wonder that the 10/23 WSJ reported that President Donald Trump directly accused Powell of endangering the US economy by raising interest rates: “I’m just saying this: I’m very unhappy with the Fed because Obama had zero interest rates.” He also complained that “[e]very time we do something great, [Powell] raises the interest rates.”

I am convinced that last month’s stock market rout started on October 3, when Fed Chairman Jerome Powell said in an interview with Judy Woodruff of PBS: “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore.” CNBC also reported that Powell said: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” The CNBC article was alarmingly headlined as follows: “Powell says we’re a long way’ from neutral on interest rates, indicating more hikes are coming.”

The S&P 500 dropped 9.1% from the close on October 2 through last Friday’s close as Fed officials continued to hammer home Powell’s narrative (see top chart).

For example, in his first public speech as vice chairman last week on Thursday, Clarida explained why he thinks higher interest rates are in order. Sadly, it’s the same old party line that Fed officials have been spouting for a while to explain their gradual normalization of monetary policy. Here it is in brief:

(1) Star struck and star stuck. Clarida along with other Fed officials are star struck. They are stuck on the fanciful notion that the federal funds rate should be set relative to “the longer-run neutral real rate,” often referred to as “r-star,” or “r*.” Clarida acknowledges that it is an “unobservable and time varying” variable. However, fear not: It is “computed from the projections submitted by Board members and the Reserve Bank presidents.” The real rate is the nominal rate minus the inflation rate. Adjusting an overnight rate using a one-year inflation rate is just one of the many mind games Fed officials like to play.

It gets even worse: Clarida admits that r* “must be inferred as a signal extracted from noisy macro and financial data. That said, and notwithstanding the imprecision with which r* is estimated, it remains to me a relevant consideration as I assess the current stance and best path forward for policy.”

He then goes on to quote a reputable authority on matters of economic astronomy (astrology, actually): “The reason for this is because, as Milton Friedman argued in his classic American Economic Association presidential address, a central bank that seeks to consistently keep real interest rates below r* will eventually face rising inflation and inflation expectations, while a central bank that seeks to keep real interest rates above r* will eventually face falling inflation and inflation expectations.” (Friedman, of course, was the father of monetarism, which has been mostly relegated to the dustbin of economic history.)

By the way, unobservable stars tend to be black holes!

All this suggests that the best measure of whether the real (and nominal) federal funds rate is too low or too high relative to the phantom r* is the actual inflation rate. So by Clarida’s own logic, if inflation remains subdued around the Fed’s 2.0% target, as it continues to do, why should the Fed raise interest rates at all?

(2) The new abnormal. That’s a good question. The Fed’s house view is that monetary policy has been set on a course of “normalization,” with the aim of raising the nominal federal funds rate to a more normal and neutral level of 3.00%, after interest rates were near zero from 2009 through 2015. The problem is that no one really knows if that’s the right level after so many years of abnormally easy monetary policy. What if the neutral federal funds rate is 2.00% rather than 3.00%? In that case, further rate hikes will be restrictive even though inflation remains subdued. (See our FOMC September 2018 Summary of Economic Projections, September 2018-2021 & Beyond tables.)

That’s why the stock market plunged in October. Instead of setting the course of normalization on autopilot with 25bps hikes following the March, June, September, and December meetings of the FOMC, why not try a more gradual pace of increases with longer pauses to assess whether the course of normalization needs to be recalibrated?

(3) Accommodative or not? Recall that the latest, 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. In his press conference that same day, Powell minimized the import of this development, saying that the language simply had outlived its “useful life.” He contradicted that assessment on October 3, helping to set the stage for October’s stock market meltdown.

Furthermore, how does that square with Clarida saying that the federal funds rate needs to be raised some more because it is still below r*? There certainly is a big inconsistency between the change in the 9/26 statement and Clarida stating, “However, even after our September decision, I believe U.S. monetary policy remains accommodative.”

(4) Phillips’ disciples. Now that the unemployment rate is down to 3.7%, the lowest since December 1969, Fed officials seem most concerned that the tight labor market will boost inflation. They’ve mostly admitted that the Phillips curve trade-off between unemployment and inflation has flattened out. Yet they still fear that it will make a big comeback unless they continue to raise interest rates. Granted, wage inflation has risen recently to 3.0%, but it might very well be justified by a long-awaited rebound in productivity growth.

Nevertheless, Fed officials figure that by raising the nominal federal funds rate to a neutral rate of 3.00%, they will keep price inflation around their cherished 2.0%. However, their latest dot plot shows that the FOMC’s median estimate of the longer-run unemployment rate—a.k.a. “NAIRU,” the nonaccelerating inflation rate of unemployment—is 4.5%.

In other words, they are saying that to keep a lid on inflation, they have to raise the federal funds rate—up to a restrictive 3.40%, they currently reckon according to the latest dot plot—until the jobless rate rises back from 3.7% to 4.5%! That would imply a sharp economic slowdown indeed. So they figure that they could then lower the federal funds back down to their cherished 3.00%, i.e., the nominal version of r*.

Yet Clarida admits that NAIRU might be lower than 4.5%. So far, it certainly seems to be lower given that a 3.7% jobless rate isn’t boosting inflation much at all (see bottom chart). In his speech, Clarida said that NAIRU “may be somewhat lower than I would have thought several years ago.” He added: “With unemployment falling and wage gains thus far in line with productivity and expected inflation, the traditional indicators of cost-push price pressure are not flashing red right now.” You think?

(5) Raising rates to lower them. I believe that Powell is more of a pragmatist than Yellen. His unspoken game plan may simply be to raise the federal funds rate to 3.00% or even 3.50% so that when the next recession occurs, the Fed will have 300-350bps of leeway between the federal funds rate and zero. That’s fine, but longer pauses between rate hikes may increase the odds of raising the federal funds rate that high without triggering a financial crisis and a recession.

(6) Trump’s regrets. It’s no wonder that in the 10/23 WSJ interview linked above, Trump said: “To me the Fed is the biggest risk, because I think interest rates are being raised too quickly.” As for why he thought Powell was raising rates, Trump said: “He was supposed to be a low-interest-rate guy. It’s turned out that he’s not.” Does Trump regret nominating Powell? It’s “too early to say, but maybe,” the President said. Think of Powell and Clarida as Trump’s regrettables.

I was on CNBC last Friday. My message was: “We need the Fed to pause here and just take a breather. Let’s see how the economy plays out, and that will help the stock market a lot.” I concluded: “Fed officials have been talking like mission accomplished—that it’s the best economy that we’ve ever had. If it’s the best economy that we ever had, why raise interest rates? Why not leave it be if it’s growing with low inflation?”

Fed’s R-Star Is A Black Hole
Dr. Ed Yardeni
Dr. Ed Yardeni is the President and Chief Investment Strategist of Yardeni Research, Inc., a provider of independent investment strategy and economics research for institutional investors. In this blog, we highlight some of the more interesting relationships and developments that should be of interest to investors. Our premium research service is designed for institutional investors.

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