Yesterday at an event hosted by the Economic Club of New York, local economists were fortunate to hear the Federal Reserve Chairwoman Janet Yellen speak about monetary policy. After a dovish conclusion to the March meeting, remarks from Fed members such as Bullard, Lacker, Williams, Lockhart, and Evans confused the markets when they provided a more hawkish outlook. The conflicting comments highlight the ambiguity of the Fed's monetary policy which often proves to be discouraging for investors. Unlike the impressive show of coordination during the financial crisis in 2008, central banks across the globe have settled for a fragmented approach to monetary solutions in the current global slowdown. The ECB continues to expand its quantitative easing, the Bank of Japan experiments with negative interest rates, all while the Federal Reserves tries to find ways to raised the Fed funds rate. Amidst the chaos, Janet Yellen's speech sought to clarify the Fed's unkempt thought processes using her eloquent Fedspeak.
The cautious FOMC once again reiterates that only gradual increases in the Fed funds rate are due this year because of low inflation and high volatility. Yellen repeated a phrase often used by her committee, "expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate," in hopes that the markets will settle. In reality, the Fed's median projected GDP growth this year is 2.2 percent only 0.3 percentage points higher than last year. Prospects for growth don't actually improve either. For the years 2017 and 2018, the median projected change in GDP drops 0.2 percentage points to a measly 2.0 percent. To wait for such a minuscule amount of growth to raise rates is very dovish, and, in my opinion, a very dangerous move.
This low-interest environment that was discussed in Monday's article and now in Yellen's speech suppresses the yield on the bond, encourages debt, and spoils the chance for an American to save. Think about this metaphor. Imagine the economy is on a giant slingshot, and the Fed has the ability to pull back the strap to launch it and relieve the tension. Every meeting that interest rates aren't increased, the slingshot inches back and tension on the strap increases. There will be a point in time where the Fed can't pull back anymore and must let go. The tighter the slingshot, the faster the economy will crash into something and relapse back into the hands of the central bank.
With all the tension, equities have shown incredible growth during the period of low-interest rates as businesses were more than happy to take advantage of cheap capital. But the growth in stocks came at the suffering of U.S. treasury bond yields, one of the safest securities on the globe. Yields initially grew when investors' money exited these safer assets for the equities that were maintaining a recovery, but large-scale quantitative easing headed by the Federal Reserve pushed the yields down even further as the economy started to recover and credit markets stabilized. During 2010 and 2011, the economy appeared to be in a calmer condition with the exception of unemployment still running at about 9%. These years, with equities 40% higher, would have been ideal periods where the Fed could have at least considered gradual rate hikes before treasury bonds became almost useless in 2012 and 2013.
In her speech, Yellen reported the Fed's desire to "respond to the economy's twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals." This statement confuses me. In the past five years, the S&P 500 has been skyrocketing up 50%, 60%, 70, and eventually 80 to 90%, a remarkable recovery from the financial crisis and, by anyone's definition, an economy with little "twists and turns" to navigate, minimal volatility, and healthy inflation. Why weren't rate hikes ever seriously discussed then? Instead, a low-rate environment has turned from being a solution to creating a problem that feels like it should have been preventable.
The chart above shows VIX since the beginning of the zero-bound interest rate period. Clearly, the Federal Reserve had plenty of other stretches with lower volatility where the Fed funds policy could have been changed, especially during a stretch in 2012, 2013, and early 2014. During these years, GDP and inflation were showing modest growth with unemployment dropping every year both trends better than they were now.
Low oil prices, low treasury yield, low inflation, and low output all define the environment in which the Federal Reserve is forced to raise rates, a place no conventional monetary policymaker would want to be. To make matters worse, central bankers are looking at energy prices and low inflation that they have no power over (and, really, never had power over). The weapon they should have to fight the downtrend was drained in 2009, and the economy and its investors are paying the price. Because treasury yields are so low, investors will want to skip out on investing in those bonds because stocks could increase and provide a higher yield in a short time frame. As money flowed out of equities, markets froze and planned to wait out the low oil prices.
And their's the disconnection. The misunderstanding. Every individual who planned on waiting out the oil glut didn't plan on it lasting into 2016. The Federal Reserve might have been in the same boat and their persistent reiteration that inflation "will move up to 2 percent" gives me the impression they were waiting to raise rates when energy prices stabilized. As a result, real interest rates grew because of deflation, as reported by the IMF, and the economy contracted further.
What are the ways forward? Even though the Federal Reserve missed periods more appropriate for gradual rate hikes, the Governors should restart the campaign for higher interest rates in April. The oil price misunderstanding due to illicit expectations can only be ameliorated by a stabilization in prices, and investors confronting low oil prices for longer head on. In addition, central banks across the globe should begin to support treasury yields and softly encourage saving which will improve financial confidence and lead to a recovery in personal consumption. These adjustments will also be accompanied by a shift in expectations that will prepare investors for the new environment they will be trading in. Yellen's comment that "the return to 2 percent inflation could take longer than expected and might require a more accommodative stance of monetary policy than would otherwise be appropriate" is an ideal start to the acknowledgment that the Fed screwed up and the recognition that a different kind of solution is necessary for this situation.
Sources: Yellen Speech, Fed Projections