Fed wants "neutral" rates

[WendyBG]

The mandate of the Federal Reserve is to be a lender of last resort during a liquidity crisis and to maintain maximum employment consistent with a stable currency (low inflation). The Fed does NOT have a mandate to support the asset markets (stocks, bonds, real estate) although they have done this for the past 10+ years.

The Fed has a difficult job because consumer price inflation results from extra cash in consumer hands – which was provided by Congress to the tune of about 10% of GDP in 2020-2021. Fed actions control the cost of money to the banks (monetary stimulus), not to consumers (fiscal stimulus). The Fed’s actions impact asset prices much more than consumer prices. Monetary impacts on consumer prices are indirect and slow.

https://www.wsj.com/articles/behind-the-feds-slow-pivot-to-t…

**The Fed Missed Inflation. Can Jay Powell Tame It Without Causing a Recession?**
**Chairman engineered an economic rescue but now has tricky task of cooling prices without hampering growth**
**by Nick Timiraos, The Wall Street Journal, 2/15/2022**
**...**
**<huge snip>**
**....**

**At their meeting next month, Fed officials will release new projections showing how much they expect to lift rates. Thus far, their goal has been to raise them to “neutral,” a level that neither spurs nor slows growth, which officials estimate is between 2% and 3% when inflation is near the Fed’s 2% target. [** [“Rates” means the overnight and fed funds rates, which are short-term rates. The Fed wants to stop controlling long-term rates by ending their buying Treasury and mortgage bonds. – W] **...**

**Complicating its deliberations, the Fed has more than one way of tightening policy by shrinking its bondholdings [long term], which have more than doubled to $9 trillion since March 2020....**

**Looming over this is the reaction of the markets. Stocks, corporate bonds and real estate all reached historically high valuations in part on the assumption rates would remain very low for years. Though household borrowing as a share of U.S. gross domestic product is well below levels reached during the housing boom of 2004-06, corporate debt is near a record high....** [end quote]

This is a long article with a lot of information. These few paragraphs hold the meat for us as investors.

The Fed has not held its Fed funds rate at 2% - 3% since 2019. Currently, it’s 0.08%. Raising it to the “neutral” rate of 2%-3% would flatten the yield curve unless long-term yields also rose – which they will if the Fed sells even a fraction of its huge book of bonds.

https://fred.stlouisfed.org/series/FEDFUNDS
https://stockcharts.com/freecharts/yieldcurve.php
https://fred.stlouisfed.org/series/WALCL

“Neutral rates” sounds very benign. In fact, it should be very benign. The Fed is supposed to support the economy, not control it.

The problem is that rates at all maturities are so far below “neutral” or their historic norm that any attempt to return to neutral will devastate both bond owners and companies that have to borrow. Especially companies that can’t pay their debts from cash flow and must borrow to roll over existing debt. That’s a path to bankruptcy.

Bond yields are already rising. I think that there will be more to come. This is not a good time to be holding long-term bonds.

It’s also not a good time to be holding the shares of companies that have a lot of debt, especially short-term debt that will need to be rolled over soon. Especially companies that aren’t profitable. More than 600 U.S. companies are zombies, defined as not making enough money to pay the interest on the debt they’ve accumulated. The Fed says that roughly 10 percent of public firms and five percent of private firms are zombies. Listed firms classified as zombies are highly concentrated in the manufacturing sector.

https://www.millionacres.com/real-estate-investing/articles/…

https://www.federalreserve.gov/econres/notes/feds-notes/us-z…

The bland term “neutral” can lead to some very un-neutral results in the asset markets.

The pressure on the Federal Reserve to control consumer price inflation – which is largely caused by factors out of its control – could cause actions that smack down asset price inflation. That is, the value of our stocks and bonds.

Wendy

[steve203]

The pressure on the Federal Reserve to control consumer price inflation – which is largely caused by factors out of its control – could cause actions that smack down asset price inflation. That is, the value of our stocks and bonds.

As we have seen, over the last dozen years, the Fed’s primary remit is the care and feeding of the financial interests. Who owns most of the stocks and bonds?

Steve

[Leap1]

which is largely caused by factors out of its control

Wendy,

That is not true. But we have been down this path.

[captainccs]

As we have seen, over the last dozen years, the Fed’s primary remit is the care and feeding of the financial interests.

That is what the cabal concocted at Jekyll Island back in 1910.

The Captain

[MrPlunger]

Long post alert!!

The Fed’s statement that inflation is always a monetary phenomenon is full of hubris and self importance.

Inflation is caused by an excess of demand over supply … so prices are bid up.

There is always an excess of desired demand, inflation occurs when that can be realised … ie the wannabe buyers can access funds to actually buy. So there is a monetary element but it’s only part of the picture.

It’s the 99% who do the buying of stuff (maybe actually the 90%), the more wealthy have a much lower propensity to spend out of what they have available.

For the 90% they get funds by

1. Real earnings from employment.
2. Government handouts and subsidies
3. Profit / dividends from asset holdings
4. Borrowing

It would be great if earnings was the main source, spent on stuff and so becomes some-one else’s earnings in a circular fashion. In the 1970s we thought inflation would always be with us because of incessant demand via this circular route … and very high taxation levels of high earners (at least in UK).

However over the past 40 years the 90% have lost relative earning power from

1. More of the share of earnings going to upper management
2. More of the share of corporate revenue going to profit
3. More free trade leading to cheap imports and a net trade deficit leaking money from the domestic economy
4. Gig workers completely losing wage bargaining power vs unionised labor.

So those people who would like to buy stuff have been constrained … hence no inflation.

Did the Fed help? Yes in 1980, causing a recession so workers lost jobs, demand was reduced below potential supply. Since then … one could argue the Fed has just been reactionary, reducing rates as inflation naturally dwindled as a consequence of the factors above.
To say it’s the Fed that conquered inflation over the past 40 years is bonkers if you aren’t a Fed governor and arrogant beyond belief if you are.

So what’s happening now? Well we had a couple of trillion dollars fiscal stimulus … mostly put directly into the hands of consumers. As Larry Summers, who has been on top of this all along, says: it’s a wartime level of stimulus relative to GDP. That’s great, much more focussed in the right place to be spent than the Fed’s asset buying.

The result, alongside COVID and other supply constraints is a surge in GDP … up to the economy’s limited capacity. And a surge in net imports. Larry Summers says it is absurd that still TODAY (the Fed is still increasing its balance sheet as I write) the fed is ADDING accommodation in this scenario. And running a real interest rate of MINUS 7.5% p.a. But they are!!

And that’s why Wendy is probably right that bond yields will need to rise more and short term rates rise a lot before the inflation generated is contained. How far? Well how about a zero real rate? 7.5% Fed Funds! Maybe even a bit more to put downward pressure on inflation, a small positive real yield? People so far are only talking 2-3%.

There are reasons rates probably won’t get that high any time soon.

1. The stimulus does to an extent get recycled in the economy as people spend it, that’s some-one else’s earnings and so they now have it to spend … and on and on. But there is leakage in the system – some of the spend goes to net imports, that’s lost from the US economy; some of it goes to profits that are mainly not spent back into the economy by the business owners and shareholders; of course much goes to executive compensation these days, not those who would re-spend. So the stimulus will linger but become ever weaker.

2. There may be a net tax increase so the government can reduce its bloated deficit. OK this is likely to hit the wealthier harder than the 90% but will be a net drag.

3. Assets are already taking a hit from even the modest rise in market rates, reducing peoples’ comfort over spending, again mainly the 10% but a definite effect.

4. As rates rise, it’s a cashflow issue. We’re used to very low borrowing costs. Even if real rates are negative, the cash outflow for say a mortgage of a car loan has sticker shock. Mortgage 4% now not 2% … the bank simply won’t let you borrow as much. Spending constrained.

The market’s current view is that rates will go up about 2% over the next year but then it’s very uncertain.

My own view … well first that the Fed is absurdly arrogant forecasting rates out 2 years plus. That’s because the system is unstable. If inflation creeps up, real rates get more negative, this fuels the economy and inflation accelerates. Actually if the fed want stability, it has to be proactive and raise rates more than the inflation increase to exert downward pressure via an increased real rate. If inflation creeps down, the fed needs to get rates down by more in order to reduce the real rate.

Suggesting there is a steady neutral nominal rate is just not the way it works. There can be an average rate that the fed nudges the economy around … maybe it’s zero real, so 2% with 2% inflation. But that’s not going to be a steady rate. But who knows, it’s driven largely by the leakage factors listed above.

It looks like in this cycle the Fed is behind the curve again. Adding pro cyclically to the economy’s volatility when their main function is to reduce volatility. Sigh. So expect a repeat of 1999-2000 and 2005-2006, boom and bust, the fed fearful of what we’re coming out of not what we’re going into. The fed belatedly raises rates too far because they let things get too hot, the excessive rate then causing more of a recession than was needed. Maybe another crash.

Same as 1998-1999, add fuel to the fire (ostensibly to help emerging markets) … bubble forms … in 2000 tighten just as a recession owing to over ordering inventory was about to hit … collapse.
Same as 2004-2006 slowly tighten and tighten … see a bubble form … keep financial conditions tight in 2007 and 2008 to squeeze the bubble … pop.

Let’s see how quickly they can move now they know they need to. The faster initially, the better. To get on top of things. And so as not to still be hiking as the stimulus recedes. But their institutional inertia is self defeating.

[captainccs]

The Fed’s statement that inflation is always a monetary phenomenon is full of hubris and self importance.

Inflation is caused by an excess of demand over supply … so prices are bid up.

Excess demand is created by excess money to pay for it. Where did the money come from?

There is always an excess of desired demand, inflation occurs when that can be realised … ie the wannabe buyers can access funds to actually buy. So there is a monetary element but it’s only part of the picture.

Lack of supply would do it too. Covid lockdowns? Covid mandates? Buy extra toilet paper just in case creating empty shelves and scalping. Private car sales increased as people want to avoid dangerous public transport. A parts shortage looms and car makers over order, not toilet paper but silicon chips. Or was it the other way around, carmakers fearing reduced sales canceled chip orders (just in time inventory). Chip makers reduced production, etc., etc., etc.

There are so many alternatives (complex systems) that anyone trying to simply connect the dots is bound to fail. That’s why central planning is such a bust. The Fed is a Central Planner. The Fed is a bust by design. Its true job is to save Wall Street bankers from their own stupidity. In economic terms, the Fed is an externality that costs tax payers lots of money.

The Captain

ex·ter·nal·i·ty | ?ekst?r’nal?de |
noun (plural externalities)

1 Economics a side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost of the goods or services involved, such as the pollination of surrounding crops by bees kept for honey.

The Dictionary