Fundamental Macro

A very interesting paper by Hamilton (et al.) out last week looked at the question of neutral real rates in the US (and elsewhere), and how they compared over time with average or ‘trend’ growth rates. Also out last week, was a really important speech by John Williams of the SF Fed, “The Economic Outlook and Its Implications for Monetary Policy”. While each of there could easily have an entire post devoted to them, I thought I would bring them together here, because they neatly dovetail into why I think the Fed could start hiking in June (or September at the latest) should the economy continue on its current trajectory.

I have been of the view for some time (at least 6 months) that the headwinds facing the US economy following the financial crisis were very much abating. These headwinds were closely associated with the large financial imbalances in the banking and household sector which resulted from the excessive leverage built up over the mid-2000s. When the crash happened, the banking system needed bailing out in order to start the process of balance sheet repair and the worst recession since the 1930s ensured that household balance sheets were also forced to start the repair process. Roll the clock forward 7 years and both are looking considerably better.

Bank capital ratios are the healthiest they have been for decades and household debt as a share of income is back to the level seen in the early 2000s (and materially lower than in countries such as the UK, Canada and Australia).

While household flows also give a pretty robust picture, with the personal saving rate also around the early 2000 levels.

The final leg of the balance sheet adjustment comes from the government, but that has also progressed better than expected, with the net fiscal drag expected to be minimal over the coming year. (Non-bank corporate balance sheets were not particularly bad going into the crisis, so didn’t need to make a similar adjustment.)

It was these balance sheet constraints that post-crisis meant there was both a lack of both supply of – and demand for – credit, retraining household consumption and the housing market. More recently the sharp fiscal tightening in 2012 and 2013 acted as a further headwind to growth.

So how does all this relate back to the two papers I cited above? I believe that these headwinds have been a key force in driving down the ‘neutral real rate of interest’. (That is, the risk-free rate that would deliver a zero output gap and steady inflation around the target.) This is similar to the argument made by Hamilton et al when they say: “We conclude that changes over time in personal discount rates, financial regulation, trends in inflation, bubbles and cyclical headwinds have had important effects on the real rate observed on average over any given decade.” They go on to conclude that their “analysis using cross-country data and going back to the 19th Century supports a wide range of plausible central estimates for the current level of the equilibrium rate, from a little over 0% to the pre-crisis consensus of 2%. “.

I expect that the crisis drove the neutral real rate deeply into negative territory, forcing the Fed to cut the Funds rate to (effectively) zero and embark on a large scale quantitative easing programme. In other words, in order to deliver stimulative policy, the Fed needed to an enormous amount. Any less would have, in fact, felt like a quasi tightening.

However, if you accept the argument that the financial headwinds are abating, then that should imply that the neutral real rate is rising. I doubt it is back to anything like 2% – which was the consensus pre-crisis – not least because lending spreads remain materially wider, but I do think it could be back to zero or even a small positive. If it has indeed been moving higher, then the Fed has, in effect, been providing even more stimulus to the economy just by keeping policy unchanged.

Of course one big problem with this hypothesis is that one cannot directly observe the neutral real rate. Hamilton et al use a purely empirical approach, while others, such as Laubach and Williams (2003) use a structural model. Both currently assess the neutral real rate to be zero or slightly positive. That compares to a current actual real policy rate of around -1.5% (depending on your measure of inflation expectations). An alternative quantitative approach is simply to look at the rate of growth in the economy. If policy is too accommodative, then growth should be on a rising path (all else equal). Smoothing through the noise, I think there is good evidence to suggest that the US economy has indeed been accelerating over the past year (whether you use an activity measure, such as GDP, or performance of the labour market). So I think this is at least corroborative evidence of a rising neutral real rate.

Which brings me on to the second reference at the start of this post – the speech by William (the same one who co-authored the 2003 paper mentioned above). John Williams has arguably been a dovish centrist since joining the FOMC. He is famously a protegee of Janet Yellen at the SF Fed, and is therefore thought to be closely aligned in the framework he uses to assess the economy.

I thought his speech last week was remarkably upbeat (for a dove). He set out the case for starting the normalisation process in the middle of 2015. To be fair to Williams, this has been his stated view for some months. But his articulation was particularly interesting. He expects unemployment to be at or below the NAIRU during the second half of 2015. He believes that the impact of oil price shock and the dollar will be transitory for inflation, and therefore not something he will likely put much weight on in deciding when to hike. Indeed, he was at pains to point out that the lags in monetary policy mean that you need to look 18-24 months ahead when setting policy today, well beyond the period in which these relative price shocks usually matter for headline inflation. He is quite confident [his words] that inflation will move up towards 2% as the labour market tightens, wages rise and inflationary pressures increase. (On wages, he cites some research from the SF Fed that suggests wage growth has been restrained for longer than usual by nominal downward rigidities during the recession, and that they should bounce back pretty quickly as the economy grows more quickly.)

In his final section on the implications for monetary policy, whilst avoiding the technicalities of the neutral real rate argument, he essentially says that the Fed will need to start hiking not to have tight policy, but just to take back some of the extraordinary stimulus. In his words, he wants to ease off the gas.

Perhaps most telling though, is the comparison he makes to the 1960s. He argues that the current state of the economy is not that different to 1965, when the Fed were considering hiking, but didn’t. In 18 months time the “economy was on a tear”, with inflation above 3%.

So, while we have heard in recent days that FOMC members Fisher (about to retire) and Mester are both considering the merits of a hike in 2015H1, they are both renowned hawks and so one shouldn’t get too excited about their ability to move the centre of the Committee. Williams, on the other hand, is likely to give a much better read on Yellen and co., and he is arguing for a steady hiking cycle to begin around the middle of 2015.