By Mike Dolan
LONDON (Reuters) – If Fed steers on the time it takes interest rate hikes to hit the real economy are anything to go by, the state of the economy this summer will define the endgame.
The U.S. Federal Reserve clearly knows it’s tightened credit a lot already – the past 12 months have seen the biggest official interest rate rise in more than 40 years. It’s just far less certain when all that kicks in on demand – or at least slows things down enough to sink inflation back to target.
Although markets now appear to finally agree with Fed guidance on completing the cycle in July – at a peak rate 75 basis points above the current 4.50-4.75% range – the slippery concept of policy lags dictates whether it plays out that way.
At its latest meeting, the Fed laced its statement and minutes with a rider about cumulative tightening and uncertain lags.
And yet the timing of those lags likely splits the hawks and doves – the latter fearing that traditional assumptions of long 18-24 month lags risk policy overkill now if the economy is already weakening by the time existing hikes begin to hit home.
Hawks assume the transmission is far quicker these days and the ongoing buoyancy of the jobs market, retailing and the service sector shows little damage so far and more work to do.
In an interview with CNBC on Wednesday, hawkish St Louis Fed chief Jim Bullard reckoned what the Fed has done to date had already been well absorbed and more needed to be done.
“This is the age of forward guidance and so the long and variable lags argument doesn’t make as much sense as it made decades ago,” said Bullard, who doesn’t get a vote this year on the rotating policy committee.
“Financial markets did a good job in adjusting.”
The gist of the argument is that the Fed doesn’t deliver credit directly to the wider economy – banks and financial markets do. And if the Fed is now communicating its future policy intentions successfully – unlike 40 years ago – and lenders and markets respond accordingly, then the impact of the whole Fed cycle is pretty quick, or at least quicker than it was.
That’s why there’s so much attention paid to broader ‘financial conditions’ and behaviour of stock and bond markets. Given that, the Fed should be reasonably wary of any confluence of ebullient markets and brisk growth if inflation is still way above target.
That’s not the full picture of course – some lags always exist for borrowers refinancing fixed rate mortgages and loans or realizing asset gains or losses at later dates, and also in annual wage rounds.
But few seem to doubt that these policy lags have shortened considerably over the decades.
Graphic 1: Fed chart on Jan proxy funds rate, https://fingfx.thomsonreuters.com/gfx/mkt/gdvzqmqxxpw/Three.PNG
Graphic 2: U.S. Financial Conditions, https://fingfx.thomsonreuters.com/gfx/mkt/egvbyoyropq/Two.PNG
LAGGARDS
Speaking last month, Fed board governor Chris Waller said the 12-18 months’ range once assumed no longer applies and he estimated policy moves now landed in just 9-12 months.
If that’s true, then the first Fed hike in the cycle should be making itself felt now and raises eyebrows about talk of a re-acceleration of growth into the new year.
However, as Bullard stresses, the first half of the cumulative 450bps of tightening was just to get the Fed funds target back to an assumed ‘neutral’ rate around 2.5% – just to stop it actively stimulating the economy after the uber-easy settings of the pandemic.
So presumably a 9-12 month lag from the point at which policy rates turned restrictive above 2.5% last September would take its toll this summer – where the terminal rate is priced.
Fed officials are not picking that estimate from thin air.
A paper by Kansas City Fed economist Taeyoung Doh and the San Francisco Fed’s Andrew Foerster late last year estimated that the lag had shortened markedly since 2009 as a result of both forward guidance and use of the Fed balance sheet.
It concluded that the biggest deceleration in inflation occurs about one year after tightening.
And it now models a proxy funds rate that incorporates these additional policy tools. Although only updated at the end of each month, January’s estimate – just before the Fed’s latest rate rise – was 6.1%, almost 150bps above the official target rate at the time, although already 35bps below November’s peak.
“If financial market conditions tighten as policymakers provide forward guidance, the proxy fund rate can rise, even if policymakers have not raised the federal funds rate,” they said.
Showcasing the study in December, San Francisco Fed chief Mary Daly adopted a more dovish slant on the gap between the funds rate and tightening financial markets. “Ignoring it raises the chances of tightening too much.”
For markets, it’s yet another lesson in not fighting the Fed too much – or drifting too far from its guidance.
Former Fed vice chair and now Pimco economic adviser Richard Clarida pointed out this week that the last time Fed rates were at 4.75% – on their way to a peak of 5.25% – was in 2006.
“A crucial difference today as compared with previous major rate hike cycles is communication.”
“But investors should remain attentive to the occasional episodic disconnects observed between Fed guidance and some prominent indices of financial conditions,” Clarida told clients.
“While financial conditions according to some indexes have eased somewhat… the U.S. economy likely has not yet absorbed the full force of Fed tightening to date.”
Graphic 3: The Fed waits on services, https://www.reuters.com/graphics/USA-FED/INFLATION/lbpggbxgepq/chart.png
Graphic 4: Fed rate cuts: not so fast? , https://www.reuters.com/graphics/USA-FED/RATECUTS/klpygdgzqpg/chart.png
The opinions expressed here are those of the author, a columnist for Reuters.
(Writing by Mike Dolan, Twitter: @reutersMikeD; Editing by Susan Fenton)