Wary Fed Rethinks Pace of Hikes

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The Wall Street Journal  /  June 15, 2016

The Federal Reserve held short-term interest rates steady and officials lowered projections of how much they'll raise them in the coming years, signs that persistently slow economic growth and low inflation are forcing the central bank to rethink how fast it can lift borrowing costs.

Wednesday's moves marked a stark reversal from just a few weeks ago, when several Fed officials, including Chairwoman Janet Yellen, dropped strong hints they might raise rates in June or July. Instead, she emphasized the central bank's uncertainty about when they'll act and where rates are headed in 2018 and beyond.

"I can't specify a timetable," about when rates will next be raised, she said at a press conference following the Fed's two-day policy meeting. "We are quite uncertain about where rates are heading in the longer term."

Those metrics don't add up to a booming economy, but the expected performance is better than that of other large developed markets, including Japan and the European Union, which are struggling with slower growth and lower inflation. The expected growth also marks a steadiness that stands in contrast to China's economic slowdown.

The combination of relatively stable economic projections and a lower interest-rate outlook suggests officials are coming to the conclusion that the economy simply can't bear very high interest rates, even to achieve the mediocre growth and low inflation officials have in mind.

Ms. Yellen previously said she believed temporary headwinds were holding back the economy. She conceded Wednesday that such drags, such as slow productivity growth, might persist. Moreover, new ones, such as China's slowdown, are emerging.

Notably, Ms. Yellen won a unanimous vote on Wednesday's policy statement. Kansas City Fed President Esther George, who dissented in March and April in favor of a rate increase, instead voted with the majority.

Fed officials have been weighing whether the economy's equilibrium interest rate—a rate at which the economy is in balance, growing with stable inflation and low unemployment—has fallen because of long-running trends holding back growth and beyond the Fed's control, such as the retirement of older workers and low productivity growth.

Paul Willson, chairman of the $550 million-asset Citizens National Bank in Athens, Tenn., worries an increase in interest rates now could knock the economic expansion off course.

Mr. Willson likens the Fed's low-rate policy to an aircraft flying low to the ground: With rates so close to zero, the risks of a policy misstep are greater. "We've got enough viable air speed but we don't have much altitude," he said of the U.S. economy. "And that worries me. Any missed input could screw things up."

The Dow Jones Industrial Average retreated after the Fed's release, finishing the day down 34.65 points, or 0.2%, at 17640.17 after trading in positive territory leading into the release. Yields on 10-year Treasury notes, which tend to go down when investors become risk-averse or pessimistic about growth, dropped to 1.594%, the lowest level since December 2012.

The central bank in December lifted its benchmark federal-funds rate up from near zero to between 0.25% and 0.5%. Officials indicated then they expected to push rates up four times in quarter-percentage-point increments this year to 1.375% at the end of 2016.

Instead, their rate target has been unchanged since December and they have cut in half their expectations for rate rises this year.

The economy and financial markets haven't cooperated with the Fed's plans. Early in the year, market turbulence and slow economic growth gave officials pause. Growth appears to have picked up and markets have largely settled down, but now hiring and expected inflation are a cause of concern for officials. "Recent economic indicators have been mixed, suggesting our cautious approach to adjusting monetary policy remains appropriate," Ms. Yellen said Wednesday, while noting that observers should not read too much into any one report.

The new projections released Wednesday showed officials expect the fed-funds rate to rise to 0.875% by the end of 2016, according to the median projection of 17 officials. That implies they see two quarter-point rate increases this year, as they did in March.

However, a greater number of officials now see just one increase, rather than two moves. In March, just one official saw one rate increase this year and seven saw three or more. Now six officials see one increase this year and two see three or more.

Ms. Yellen said a rate increase at the Fed's next meeting in July is "not impossible." The tone of the Fed's official statement, its projections and her comments suggest officials would need to see a quick turnaround in economic data and evidence of market resilience if they were to move so soon.

"We need to assure ourselves that the underlying momentum in the economy has not diminished," she said.

The new projections also show central-bank officials see the fed-funds rate at 1.625% by the end of 2017 and 2.375% at the end of 2018, both lower than their March estimates.

In the longer run, Fed officials now expect the benchmark rate to reach 3%, lower than the 3.25% they saw in March.

Jeremy Ames, president and co-founder of Guidant Financial in Bellevue, Wash., said Fed officials may still be too optimistic in their projection that short-term rates will rise above 2% in the next couple years.

"I think that assumes everything is going well and everything is going swimmingly," said Mr. Ames, whose firm finances small-business startups and acquisitions. "If they hit those time frames, I would be surprised."

Traders on the Chicago Mercantile Exchange placed a 7% probability on a Fed rate increase in July and a 23.9% probability on at least one increase by September. Though most Fed officials see at least two quarter-point rate increases before year-end, traders see a 57% probability that it won't.

The June 23 U.K. vote on whether to leave the European Union was one factor in Fed officials' decision to leave rates unchanged, and "clearly could have consequences" for economic and global financial markets, Ms. Yellen said.

Fed officials last month appeared poised to raise rates in June or July. Ms. Yellen said in late May a move was probable "in the coming months" if the economy continued to strengthen—wording she has not repeated in her two public appearances since the Labor Department released a disappointing May employment report.

Employers added just 38,000 jobs last month and payroll growth in April and March was revised lower. The share of Americans participating in the workforce also declined, and the number of employees stuck in part-time jobs rose, the report showed. Still, the number of Americans filing first-time claims for unemployment insurance remains at historically low levels.

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Fed pares back 2017 interest rate forecasts

The Financial Times  /  June 15, 2016

Slower jobs growth and overseas hazards such as a possible UK exit from the European Union prompted the Federal Reserve to keep rates unchanged on Wednesday and trim back its longer-term interest-rate forecasts, in a sign of greater caution at the central bank.

The US central bank held the target range for the federal funds rate at 0.25 per cent to 0.5 per cent, where it has been since the Fed lifted rates by a quarter point from near-zero levels in December, as it assesses a mixed set of economic indicators.

The median of Fed forecasts suggests policymakers are still expecting two interest rate increases this year, but rate forecasts for 2017 and 2018 have been pared back, as has the Fed’s estimate of the longer-run policy rate.

The tempered interest rate path spurred another rally in US government bonds, despite the slightly higher inflation forecasts. The two-year Treasury yield fell 6 basis points to 0.67 per cent, and the 10-year Treasury yield slipped 3 basis points to 1.58 per cent, on course for its lowest closing level since 2012.

The US stock market fluctuated before settling at roughly the same level after the revised forecasts and new statement were digested, while the DXY dollar index fell 0.5 per cent, the most since June 3.

In a sign of greater caution on the committee, Esther George, the Kansas City Fed chief, dropped her previous dissenting call for higher rates.

Until recently a number of Fed rate-setters have been signalling they want to see another rate rise as soon as this month, but Janet Yellen, the Fed chair, stressed in early June that the Federal Open Market Committee had to weigh a range of uncertainties and risks as it gauged when to move.

Among the key question marks hanging over the US outlook is the UK’s referendum on its membership of the EU — with Fed officials flagging the danger that a Brexit could ripple back and hit US growth.

When asked whether the looming UK vote had been one of the reasons the US central bank kept rates unchanged on Wednesday, Ms Yellen said: “It is certainly one of the uncertainties we discussed and factored into today’s decision.”

A vote by the UK to leave the EU would have consequences for conditions in global markets which would in turn have implications for the US outlook, she added. “That would be a factor in deciding on the appropriate path of policy.”

Its statement noted that while economic activity and household spending have picked up recently, jobs gains have diminished and market-based measures of inflation compensation had declined — even as surveys of individuals’ inflation expectations remained little changed.

Ms Yellen gave a broadly optimistic outlook about the US economy when she spoke in Philadelphia. But she also withdrew earlier guidance that she expected a rate rise “in the coming months”, suggesting the Fed now is firmly in wait-and-see mode.

Futures markets were predicting only a one-in-five chance of a move at the central bank’s next meeting in July going into Wednesday’s announcement, with slightly stronger odds in September.

Forecasts released by the Fed showed policymakers expect two rate rises this year, leaving their median prediction for the target range centred on 0.875 per cent. Notably, however, six of the 17 participants in Wednesday’s meeting thought there may only be scope for a single increase this year.

In 2017, the median forecast is now for rates to rise to 1.625 per cent, down from 1.875 per cent in March, pointing to three rises. The median projection for 2018 is centred at 2.375 per cent, down from 3 per cent before.

Policymakers are now expecting the longer-term fed funds rate to be lower as well, with forecasts pointing to around 3 per cent compared with 3.25 per cent before, as a sluggish growth outlook weighs on forecasts.

Officials shaved back their median expectation for growth this year to 2 per cent from 2.2 per cent, and to 2 per cent in 2017 from 2.1 per cent. Core inflation is seen slightly higher this year than previously, at 1.7 per cent, but the Fed still does not see inflation returning to its 2 per cent target until 2018.

Unemployment forecasts were little changed, with policymakers seeing the jobless rate at the end of the year at 4.7 per cent, in line with its most recent reading.

Debate in the FOMC on Wednesday likely focused heavily on the jobs market, which has lost some of its lustre despite 75 straight months of expanding payrolls. Policymakers would need to see decisive evidence in the coming weeks that dismal jobs numbers in May were a one-off fluke rather than a serious setback — coupled with an end to Brexit jitters in markets — if they were to feel confident enough to lift rates as soon as the Fed’s July meeting. Markets are putting higher odds on a move by the FOMC later in the year.

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Fed's Yellen acknowledges difficulty of escaping world's low rate grip

Reuters  /  June 15, 2016

Evidence that the U.S. neutral rate of interest remains stalled near zero spurred the Federal Reserve to slow its expected pace of rate hikes on Wednesday, as policymakers signaled their hands may be tied until a rebound in global demand or other forces raise that key measure of the economy’s underlying strength.

In a news conference following the Fed's latest meeting, Chair Janet Yellen said the central bank was still coming to grips with the likelihood that the neutral rate - the point at which monetary policy is neither spurring nor restraining economic growth - is stuck at a historic low and could limit the central banks room to maneuver.

In the Fed's policy debate, "an important influence is what will happen to that neutral rate," Yellen said, noting that the central bank's "base case" is that the rate should rise alongside an improving economy and as "headwinds" from the 2008-9 financial crisis fade.

But "there are long-lasting, more persistent factors that may be holding down the longer-run level of neutral rates," Yellen said.

"It could stay low for a prolonged time....All of us are in a process of constantly reevaluating where the neutral rate is going, and what you see is a downward shift over time, that more of what is causing this to be low are factors that will not be disappearing."

Policymakers nodded directly at the problem in fresh economic projections that cut median estimates of the long-run federal funds rate to 3 percent, far below the levels common in the 1990s. Since the Fed began publishing policymakers' economic projections in 2012, estimates of the long-run rate have been cut from 4.25 percent.

"There could be revisions in either direction," Yellen said. "A low neutral rate may be closer to the new normal."

HARD TO PINPOINT

Though difficult to pinpoint, estimates of the neutral rate provide a key yardstick to gauge whether a given federal funds level is stimulating or restricting the economy.

With the Fed still trying to encourage spending, investment and hiring, a low neutral rate means the Fed has less room to move before that stimulus is gone.

Fed estimates published online show little consistent movement in the neutral rate in recent years even as the labor market tightened and growth continued above trend, confounding expectations that it would move higher in an economy expanding beyond potential.

Officials cite a variety of possible explanations, but the result is the same: until policymakers are satisfied that the neutral rate is moving higher, they face an effective cap of 2 percent or even less on the federal funds rate.

Coupled with a 2 percent inflation rate, the Fed's target, that would put the "real" federal funds rate at zero. If inflation remains below target, the ceiling on the Fed would be that much lower as well.

That is a far cry from the 3.5 to 4 percent that the Fed's policy rate has averaged since the 1990s, and means the central bank will treat each move with particular caution, current and former Fed officials say. In their policy projections on Wednesday, Fed officials slowed the pace of expected future hikes from four to three per year.

It also means the central bank would be stuck near zero, and more likely to have to return to unconventional policy in a downturn; it could also force discussion of whether to raise the inflation target in order to try to push the entire rate structure higher.

The Fed has been waylaid more than once in its rate hike plans by the state of the global economy, and held steady again on Wednesday in part because of Britain's upcoming vote on whether to leave the European Union.

But recent data and Fed discussion of the neutral rate show the more chronic influence that low global rates and weak global growth may exert on the Fed.

According to the economic model typically cited by Yellen and others in discussing the neutral rate, conditions are ripe for it to move higher and give the Fed the room it needs to raise rates.

That model, developed by San Francisco Federal Reserve Bank President John Williams and the board's Monetary Affairs director Thomas Laubach, estimates that the inflation-adjusted size of the U.S. economy moved beyond its potential nearly two years ago, and that the positive "output gap" has been growing larger.

In general a larger output gap would produce a higher estimate of the neutral rate. However, in the time since the economy moved beyond potential in 2014, the model's estimate of the neutral rate has remained below zero in all but the first quarter of this year.

BONDS DIP TO NEGATIVE YIELDS

As the Fed contemplates when to move next, the dynamics working against it were obvious this week when the yield on Germany's 10-year bond dropped into negative territory, helping keep the spread between it and the U.S. 10-year Treasury note near a euro-era high.

That gap in risk-free yields, and the United State's general performance relative to Europe and Japan, has driven the dollar higher, curbed U.S. exports, and may have fed through to the recent hiring slowdown in the U.S. industrial sector - all factors that could help depress the neutral rate.

A move higher in U.S. target rates risks reinforcing those trends, likely leading the Fed to feel its way forward until Europe and Japan can also move from the zero lower bound - a day that may be far in the future.

"If anywhere along this path international conditions or skittishness become such that the dollar takes off and capital flows disrupt a weak world and all of that affects inflation and job gains, then we will have a real fundamental question for them to resolve," said Jon Faust, a Johns Hopkins University professor and former advisor to the Fed board.

"How hard do we push on going it alone?"

 

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Fed eyes lasting impediments to growth after rethink on outlook

The Financial Times  /  June 16, 2016

Earlier this month, Janet Yellen, the Federal Reserve chair, struck a broadly positive tone about the US economy. The big picture, she declared in a speech in Philadelphia, was “largely favourable” for an economy that had registered impressive gains since the Great Recession.

Forecasts by the Fed on Wednesday tell a more sombre story. While policymakers left their predictions for economic growth and inflation largely unchanged, they now believe that the central bank will have to keep rates even lower to sustain that outlook. What was already set to be the Fed’s shallowest rate-lifting cycle in modern times now looks even more glacial.

The reason is that Fed officials have been rethinking the longer-term outlook for the US economy — and drawing some gloomy conclusions.

The Fed chair has for much of her tenure been predicting that the post-crisis “headwinds” that are holding the economy back are likely to prove fleeting. On Wednesday, however, she suggested that the economic depressants weighing on US growth and inflation could prove more stubborn than the central bank previously believed.

As a result, the so-called “neutral” rate of interest that is needed to keep the economy growing roughly at its trend rate and operating near full employment could stay stunted for a long time.

The words helped explain why Fed officials scythed back their interest rate forecasts beyond the current year, with their median prediction for the federal funds rate’s target range falling sharply in 2018 from 3 per cent to 2.375 per cent. The Fed’s median estimate for the longer-run rate now stands at 3 per cent, a full point below where its estimate stood three years ago.

Roberto Perli, an economist at Cornerstone Macro, argues Fed estimates for the longer-run target rate may need to be cut further, to as low as 2 per cent.

What is leading to the reassessment? A series of long-lasting and persistent factors may be holding down the longer-run neutral rate. The ageing of America’s population is leading to slow labour force growth as well as sluggish rates of household formation, for instance.

Crucially, productivity growth is worryingly listless. Analysis from the Conference Board suggests that the US will this year see negative productivity growth for the first time since the early 1980s, a toxic situation that could hamper income growth.

The Organisation for Economic Co-operation and Development on Thursday shed light on some of the deep-seated problems driving this story.

The Paris-based organisation struck a broadly optimistic tone about the US recovery, pointing out in a survey that output has surpassed its pre-crisis peak by 10 per cent, far outperforming the euro area and Japan, while unemployment is down sharply and the government’s fiscal position is on a better footing.

However, productivity growth has been torpid even in so-called frontier firms in industries such as information technology and pharmaceuticals. Part of the problem is a failure of companies to invest, preferring instead to funnel out higher dividends and engage in share buybacks.

Lower levels of business start-ups, plus growing market power for industry leaders that is restraining competition, may also be operating as barriers to productivity growth.

“Productivity growth has been sluggish since the Great Recession and had been slowing before it. This slowdown has touched nearly every industry,” the report concluded.

Lasting impediments to US growth are likely to weigh on the Fed’s policy outlook, perhaps even more than the central bank’s policymakers currently believe.

The grimmer outlook suggests that the so-called secular stagnation thesis of lethargic growth and suppressed interest rates espoused by economists, including former Treasury Secretary Larry Summers, may well be gaining currency.

“All of us are involved in a process of constantly re-evaluating, where is that neutral rate going,” acknowledged Ms Yellen. “And I think what you see is a downward shift in that assessment over time. The sense that maybe more of what’s causing this neutral rate to be low are factors that are not going to be rapidly disappearing but will be part of the new normal.”

Lewis Alexander, chief US economist at Nomura, said: “We believe that persistent structural factors — in effect ‘secular stagnation’ — are more likely to be the core reasons for the depressed level of the neutral rate. Therefore, we doubt the FOMC will be able to raise rates as far as it currently expects.”

Ms Yellen remained eager on Wednesday to drive home the message that the economy and inflation will grow enough to merit further rate increases. A second rise in short-term interest rates could come as soon as next month, she insisted, although her language suggested that this is something of a long shot.

But more Fed policymakers seem to coming around to the view that has long prevailed in financial markets: that increases in the fed funds rate will be languid at best.

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Fed’s Powell warns US at risk of being trapped in low growth

The Financial Times  /  August 7, 2016

There is an increasing risk that the US economy has become trapped in a prolonged period of subdued growth that requires lower official rates than was previously expected, a leading Federal Reserve policymaker has warned.

Jerome Powell, a member of the Federal Reserve Board of Governors, said he was not in a hurry to lift rates, arguing for a “very gradual” path for any rises, while warning that the US outlook was still dogged by global risks.

“With inflation below target, I think we can be patient,” he told the Financial Times.

In his four years at the Federal Reserve, Mr Powell has demarcated himself for his willingness to get stuck into the nitty-gritty of financial markets, earning himself a reputation as the Fed’s markets governor.

But meeting the FT in a wood-panelled room at the Fed’s headquarters on Constitution Avenue, he appeared as much preoccupied by the longer-term US growth outlook as by the potential for market logjams and mishaps.

Economists led by Larry Summers, former Treasury secretary, have been propounding the sobering theory that the US may be mired in so-called secular stagnation — a trap of lethargic economic growth and depressed interest rates.

For a while the Fed resisted that dismal prognosis. But Mr Powell, a level-headed centrist on the rate-setting Federal Open Market Committee, appears increasingly alive to the possibility, even if he says secular stagnation is not his “baseline” expectation.

“I am more worried about it than I was,” he said. “The probability of an era of weaker growth, lower potential growth, for a longer period of time — that worries me more than it used to.”

To achieve economic growth forecasts, Fed rates will “just have to be lower than I thought,” he added.

One reflection of the quagmire is the gradual decline in Fed policymakers’ estimates for the long-term federal funds rate.

“I don’t think that process is over,” Mr Powell said. “The median estimate on the committee is 3 per cent for the long-term federal funds rate. It could be lower than that, in my view.”

Having lifted rates in December by a quarter point to a range of 0.25 per cent to 0.5 per cent and sat still since then, the Fed is weighing conflicting signals at home and overseas as it looks towards its September meeting.

The US economy, Mr Powell said, is “not full of risk right now”.

But he added: “The issue is that if you look around the world there are just a lot of risks that could affect us. So it is a US economy that is probably pretty close to its pattern of the last seven years, but the risks to us from the global economy are to the downside.”

He said it was hard to raise rates “in a world where everyone else is cutting and demand is weak around the world”.

“The expectation of rate increases has produced a big move up in the dollar since 2014, which has restrained growth.”

Mr Powell was speaking the day before the release of jobs data on Friday that beat expectations.

To support a rate increase, Mr Powell said that he would want to see strong growth in employment and demand; inflation heading back to 2 per cent and an absence of obvious “global risk events.”

Fed policymakers are still scanning for potential fallout from Britain’s vote to leave the EU, while questions hang over China’s growth outlook.

Asked if his preconditions could be satisfied as soon as the Fed’s September meeting, Mr Powell said: “In particular, I need to see two really good employment reports. And then it is a conversation. I wouldn’t be pounding the table saying we really need to raise rates.”

The former Carlyle Group partner — a keen athlete who cycles to work every day — has spent significant parts of his career at the sharp end of Treasury market structure.

He served in the Treasury under former President George H.W. Bush, helping to formulate the government’s responses to the Salomon Brothers scandal in 1991. The firm used fake bids to purchase more Treasury securities at auction than was permitted by one institution.

Mr Powell has recently been vocal on the intricate plumbing of markets, advocating the central clearing of so-called repo transactions in a bid to alleviate some of the capital concerns that big banks blame for their pullback from the market. Repo markets are integral to the functioning of the broader Treasury market, allowing financial institutions to borrow and lend securities short term in order to cover obligations to other counterparties.

But higher capital charges have made the transfer of Treasuries more expensive.

It is part of the industry’s explanation for why liquidity, the ease of buying and selling an asset, has declined in Treasury markets.

Mr Powell has spoken in chorus with the Fed and Treasury in rejecting the industry’s concerns that market liquidity has become markedly worse. But he remains attuned to the potential for problems to arise.

“Most of the time in most markets liquidity is okay. But it may be more fragile, and more prone to disappearing in stress situations,” he says. “There hasn’t been a liquidity-related incident that has had a significant effect on the real economy. That doesn’t mean it won’t happen.”