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September 23, 2022
How Has the Market Responded to Restoring Price Stability?
The Federal Open Market Committee (FOMC) implements monetary policy chiefly through changes in its federal funds rate target, and market participants form expectations about the evolution of future monetary policy decisions based on data they think are relevant to policymakers. Between the June and July FOMC meetings, incoming data started to suggest some parts of the economy might already be feeling the effects of tighter monetary policy. On the other hand, data since July tell a different story, one that suggests the FOMC still has a way to go in its efforts to fight inflation and restore price stability. So how have market participants interpreted these disparate pieces of data, and what could they mean for future monetary policy decisions?
In this post, I use the Atlanta Fed's Market Probability Tracker to understand how data since the June and July FOMC meetings have affected the market's expectations about the path of future monetary policy, similar to the analysis I did with Atlanta Fed economist Mark Jensen in a Macroblog post late last year. As another Atlanta Fed colleague, Mark Fisher, and I discussed in a Notes from the Vault article, the Market Probability Tracker generates estimates of the expected federal funds rate path based on eurodollar futures and options on eurodollar futures. Eurodollar futures and options deliver a three-month LIBOR (the London interbank offered rate) interest rate average, which is closely linked to the federal funds rate. Additionally, eurodollar futures and options are among the most liquid of financial instruments, with contracts that are expiring several years in the future regularly traded. As a result, the Market Probability Tracker generates our best estimates of expected rate paths by incorporating all the available data that the market believes will affect future policy decisions.
Figure 1 below uses the expected rate paths produced by the Market Probability Tracker to illustrate how market expectations between the June and July FOMC meetings responded to new information about the economy. The solid black line in figure 1 below shows the federal funds rate path expected by market participants after the FOMC's meeting press conference on June 15 . The black dotted and dashed lines represent, respectively, expectations after Fed chair Jerome Powell's Senate Banking Committee testimony on June 22 and after the release of the US Department of Labor's weekly report of unemployment insurance initial claims on June 30. Although economic updates occurred throughout the intermeeting period (the New York Fed maintains a list of important releases going back to 2018 in its Economic Indicators Calendar), the changes in expectations on these two dates best summarize the overall change in the market's expectations. Lastly, the solid orange line represents expectations following the FOMC's press conference on July 27. I also include (shaded in gray) the target range of 225 to 250 basis points announced at that meeting.
Starting with the black dashed line, after the June FOMC meeting, market participants expected the federal funds rate target range to reach 375 to 400 basis points by the first quarter of 2023 and then fall 75 basis points over the course of the next two years. During his June 22 Senate Banking Committee testimony, Chair Powell said that an economic downturn triggered by rate hikes to tame inflation was "certainly a possibility," although he added that such a downturn was neither the Fed's intent nor, in his view, necessary. His statement was important, albeit qualitative, information for the market because the FOMC in the past has often responded to economic downturns by lowering interest rates, which market participants interpreted as lower overall federal funds rates in the future (represented by the dotted black line). Expectations fell even lower after the Department of Labor's June 30 report hinted at a moderating labor market, with initial claims near five-month highs (represented by the dashed black line). By the July FOMC meeting (represented by the orange line), market participants further expected rate hikes to end this year and then fall 100 basis points during the next two years, as subsequent initial unemployment claims reports remained elevated and the July 21 Philadelphia Fed's manufacturing survey showed a drop in activity.
Figure 2 shows the Market Probability Tracker's estimates of the federal funds rate path expected by market participants following the July FOMC meeting (the solid orange line). It also shows the expected rate path following the August 5 release of the July employment situation report from the US Bureau of Labor Statistics (represented by the dotted black line), the expected rate path following the September 8 release of the initial unemployment claims report (represented by the dashed black line), and the expected rate path following the September 13 release of the August consumer price index (represented by the dot-dash line). Much like figure 1, these dates best summarize how market participants reacted to the evolving data since the July FOMC meeting (despite many other data releases occurring throughout the intermeeting period). Lastly, the solid black line represents the expected rate path on September 20, the day before the press conference following the FOMC meeting.
In the eight weeks since the July FOMC meeting, the data that the Committee said it would use to evaluate future policy moves came in much stronger than expected. Rather than moderating, labor markets appeared to tighten, with the Bureau of Labor Statistics reporting a 526,000 increase in nonfarm payrolls in its July jobs report and the Department of Labor reporting a decline in initial unemployment claims throughout August that culminated, in the September 8 report, in their lowest reported levels since May. The consumer price index for August, which many had expected to fall on a month-over-month basis, showed inflation increasing 0.1 percent from July. The less-volatile core measure of inflation that excludes gasoline and food prices also rose 0.6 percent from July, twice the expected rate. Given the data's direction leading up to the September FOMC meeting, market participants expected a more aggressive pace of rate hikes through the end of the year, from 325 basis points after the July FOMC meeting to nearly 450 basis points. They also expect rates to remain much higher for much longer, with rates at the end of 2025 near 350 basis points—which would be at least 100 basis points higher than the 225 to 250 basis points that the chair described as the "neutral" policy rate at his July press conference.
Figure 3 shows the Market Probability Tracker's estimates of the federal funds rate paths that market participants expected the day before the press conference following September's meeting (the solid black line), and after the press conference on September 21 (the solid orange line). Chair Powell, in his opening remarks, commented that tight labor markets "continue to be out of balance" with demand and that "price pressures remain evident across a broad range of goods and services." The information contained in both the press conference and the material released by the Committee did not significantly change market expectations about the future path of monetary policy, which already incorporated recent data on inflation and labor market conditions.
Turning back to the question posed by this post's title, the rate path movements seen in reaction to the incoming data show that, initially, market participants expected rate hikes to end in 2022. But the data, which came in much stronger after the July FOMC meeting, led the market to expect the Fed to raise rates higher than had been expected following the June FOMC meeting. Market participants also expect the Fed to keep those rates much higher for longer in order to cool demand—as Chair Powell put it in his August 26 speech at the Jackson Hole economic policy symposium, "until we are confident the job is done."
More importantly, the movements in the rate paths highlight the insights we can gain from the Market Probability Tracker into how information about the economy affects the market's expectations of future monetary policy decisions. Chair Powell observed during the June press conference that "monetary policy is more effective when market participants understand how policy will evolve." With the rate paths produced by the Market Probability Tracker each day, we can begin to make that assessment.
August 31, 2022
Lessons from the Past: Can the 1970s Help Inform the Future Path of Monetary Policy?
People in monetary policy circles sometimes use the phrase "long and variable lags" to describe the delayed impact of the Fed's main policy tool on demand and inflation. The popularization of that phrase can be traced to a speech by Milton Friedman during the 1971 American Economic Association meetings, and since then people usually use it to describe the impact of Fed policy on economic output and inflation. Yet, during that speech, when summing up his work on the subject, he noted that "...monetary changes take much longer to affect prices than to affect output," adding that the maximum impact on prices is not apparent for about one and a half to two years.
Since Milton Friedman, many economists have studied these "long and variable lags" (including former Fed chair Ben Bernanke). And, while the length of the lag has proven "variable" as first suggested, the main result still rings true. Changes in the stance of monetary policy have the largest impact on output first and then, much later, on inflation. A large literature bears out this assertion. Bernanke et al. (1999) and Christiano, Eichenbaum, and Evans (2005) point to a two-year lag between monetary policy actions and their main effect on inflation. Gerlach and Svensson (2001) report an approximately 18-month lag in the euro area, while Batini and Nelson (2001) estimate that changes in the money supply have their peak impact on inflation in the UK after a year.
That context is especially useful for monetary policymakers to keep in mind as they navigate the economic challenges of the pandemic. In a span of just two and a half years, the US economy has suffered its sharpest post-WWII decline in economic output, a subsequent rapid resurgence in demand, a dramatic disconnect between labor supply and labor demand, widespread supply and shipping constraints, and an inflation rate that has surged from roughly 1.5 percent to 9 percent in the past 17 months. And, despite current strong job growth and the highest inflation this country has seen in 40 years, worries over a potential recession mount (as evidenced by the number of questions Chair Powell was asked about the "r word" in his press conference following the most recent meeting of the Federal Open Market Committee). These beliefs partly reflect the rapid shift in the fiscal and monetary policy stance over the past year. In response to the pandemic, Congress approved a stimulus package of $5 trillion, while the Fed expanded its balance sheet by roughly the same amount. But now, the federal deficit has fallen more than 81 percent in first 10 months of 2022 fiscal year compared to 2021. In turn, the Fed has embarked on policy normalization, raising interest rates well into the range of neutral and drawing down its balance sheet (actions known as quantitative tightening).
Although "this time is different," we might be able to gain insights into the appropriate path of monetary policy by revisiting the past. At the time of Milton Friedman's 1971 speech, the economy was coming out of what many economists saw as a policy-driven recession , which followed a period of fiscal tightening to make up for large government outlays for the Vietnam War and a sizeable slowing in money growth as the Fed attempted to quell rising inflation. Today, the main policy tool is the federal funds rate, but prior to the early 1980s, changes in the money supply were the primary instrument. (Monetary aggregates—that is, growth in the money supply—formally replaced bank credit as the primary intermediate target of monetary policy in 1970. At the time, the fed funds rate played only a secondary role and was used as guideline in day-to-day open market operations, aimed at smoothing short run volatility.) In the run-up to the 1969–70 recession, the Fed tightened policy, slowing the growth in the money supply from 8 percent on a year-over-year basis to just 2 percent (the associated increase in the fed funds rate was roughly 4.5 percentage points, to 9 percent). Yet, as quickly as the Federal Open Market Committee tightened policy in the late 1960s, it more than reversed course in response to a sizeable increase in the unemployment rate during the recession. By late 1971, the money supply was surging again, up 13 percent on a year-over-year basis.
The Fed's quick and stark policy reversal became a recurring theme in the 1970s. During the decade, the Fed quickly pivoted between battling high unemployment and high inflation, what many economists refer to as "stop-and-go" policies. Charts 1 and 2 clearly show these shifting stances as they occurred again in the run-up to and aftermath of the 1974–75 recession. Chart 1 plots the year-over-year growth rate in the money supply (M2) and the unemployment rate, and chart 2 plots the growth in the money supply against the year-over-year growth rate in consumer price index inflation.
These charts depict three points that remain salient today. First, the "stop-and-go" policies of the 1970s clearly highlight the "long and variable lags" that changes in monetary policy have on inflation. Money growth plateaus at high levels three times during the late 1960s through the 1970s: in 1968, 1972, and in the mid-1970s. Each of those periods is followed by a subsequent surge in inflation, prompting a sustained tightening of monetary conditions. But as soon as inflation began falling, the Fed quickly reversed course with a bold expansion in the money supply that overshadowed the one originating the previous cycle, citing spikes in unemployment along with a lagged decline in inflation as justifications for these reversals.
If we smooth through some of the cyclical dynamics, there was a sustained upward drift in both the unemployment rate and inflation. In the mid-1960s, both inflation and the unemployment rate were around 2 percent. And 1980 inflation was over 10 percent and the unemployment rate had drifted up to 6 percent.
This period's upward drift in unemployment and inflation ran counter to the era's prevailing wisdom, which held that higher inflation was simply the sacrifice needed to lower the unemployment rate, and vice versa, An insightful essay by former Atlanta Fed economist Mike Bryan covers this period in depth. He writes, "The stable trade-off between inflation and unemployment proved unstable. The ability of policymakers to control any ‘real' variable was ephemeral. This truth included the rate of unemployment, which oscillated around its ‘natural' rate. The trade-off that policymakers hoped to exploit did not exist."
Why didn't this stable tradeoff exist? Part of the answer is that the unemployment rate fluctuates around an unobserved natural rate. (Fed chair Jerome Powell's 2018 speech offers an accessible discussion of these unobservables.) But the other part of the answer that is particularly salient at the moment is that by the mid- to late 1970s, after enduring a sustained period of rising unemployment and inflation, people began to expect higher inflation rates.
Chart 3 plots one-year-ahead inflation expectations alongside inflation and money growth using data from the Livingston Survey, a twice-annual survey of a small group of professional economists that the Philadelphia Fed has conducted since the end of WWII. And here the upward drift in inflation expectations is striking. By 1980, inflation expectations had risen 10 percent. Our interpretation of these data is that the rapid reversals of policy that characterized Fed actions during the 1970s never allowed inflation to fall back to the 1 to 3 percent range that was the norm after the end of the Korean War. As a consequence, the expectation that inflation would not recede into the background eventually became embedded into the psyche of Americans. People who lived through this experience simply anticipated higher future inflation rates, with that expectation embedded into their price-setting and wage-bargaining decisions.
Now, history here is messy. A number of caveats and confounding factors contributed to the unfavorable economic outcomes of the 1970s. Fed historians such as Allan Meltzer argue that the prevailing Fed chair at the time, Arthur Burns, did not consider monetary policy as ultimately responsible for such high inflation. Instead, the chair pointed to unions' wage-bargaining power first and, in particular, "cost-push" shocks (that is, energy and food shortages) later as the responsible party. (And indeed, this "cost-push" theory of inflation, so prevalent at the time, merits further exploration since assuming that spikes in energy prices might have contributed to the unanchoring of inflation expectations makes sense.)
Yet, in the case of oil price shocks, there is a counterpoint. The breakdown of the Bretton Woods accords ultimately drove the sustained increase in oil prices, and their breakdown can be seen in the era's robust money growth at the time. The breakdown of these accords created a run on the dollar amid fears of inflation. The price of gold took off as many investors were scrambling for an inflation hedge. Interestingly, the increase in the price of oil actually followed the spike in the price of gold and other commodities.
The historical evidence suggests that by 1970, the attempt to defend the dollar at a fixed peg of $35 per ounce, established by the Bretton Woods agreements, had become increasingly untenable, and gold outflows from the United States accelerated amid sustained inflation and trade/fiscal deficits. The run on the dollar forced President Nixon to effectively "close the gold window," making the dollar inconvertible to gold in August 1971. One month later, OPEC communicated its intention to price oil in terms of a fixed amount of gold. Hence, the increase in the money supply, spurred by the run-up in gold prices, exacerbated the increase in the dollar price of oil and led to the high inflation that followed. OPEC was slow to readjust prices to reflect this depreciation. However, the substantial price increases of 1973–74 and 1979 largely returned oil prices to the corresponding gold parity (see chart 4), which, again, was then seen as an inflation hedge.
In this context, it's worth noting that the OPEC oil embargo following the Yom Kippur War lasted just a few months, but the price increase was permanent. Similarly, the drop in oil production following the Iranian Revolution was negligible, as Saudi Arabia increased production to offset most of the decline. Contrast these episodes to the Gulf War in 1990. Oil prices doubled during the conflict (July–October) but went back to previous levels once the war ended.
In sum, Arthur Burns leaned heavily into the notion that these cost-push shocks—and not Fed action—were ultimately responsible for inflation, effectively ignored the "long and variable" lags of monetary policy, misread the monetary dynamics, and reacted expediently to the real-side damage that high energy prices wreaked on the economy.
So let's fast-forward to today. The fiscal response to the onset of the pandemic was quite forceful—$5 trillion by most counts—and at least on par with significant wartime spending. As these transfers and disbursements hit households' wallets and businesses' ledgers, money growth surged higher than 25 percent—peaking well above, though not as sustained as, the high money-growth periods during the 1970s (see chart 5). And we've seen a sharp surge in inflation that has gone well beyond pandemic-related supply constraints and shipping bottlenecks that affected certain production inputs such as computer chips. As of July 2022, roughly three-quarters of consumers' market basket rose at rates in excess of 3 percent (and two-thirds of the market basket increased at rates north of 5 percent). These levels are on par with those we saw during the Great Inflation of the 1970s.
The Committee has begun an aggressive campaign to squelch this inflation threat, hiking rates in each of the last four meetings by a cumulative 2 percentage points along with implementing plans to reduce the size of the Federal Reserve's balance sheet. It has also indicated that more policy tightening is to come. If history is any guide, at least in broad strokes, it will take some time before recent policy actions begin to affect inflation.
And here, it appears that the FOMC is very attuned to the lessons from the Great Inflation period. In a recent speech at Jackson Hole, Chair Powell noted, "Our monetary policy deliberations and decisions build on what we have learned about inflation dynamics both from the high and volatile inflation of the 1970s and 1980s, and from the low and stable inflation of the past quarter-century." Perhaps more importantly, he emphasized, "Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy."
October 18, 2021
Market Response to Taper Talk
As the Fed discusses reducing its $120 billion in monthly purchases of Treasury and mortgage-backed securities, market pundits have begun to form opinions on whether such talk about tapering will roil markets as it did in 2013. Some believe that, given the size of the Fed's monthly purchases, such discussion will lead to similar market reactions. Others believe that markets today better understand the Fed's decision-making process around its asset purchases and interest rate policy. This market knowledge and experience may help mitigate the negative effect taper talk could have this time. In this post, we provide evidence that both perspectives are at least partially correct.
To be specific, we analyze the past and present discussions on tapering, including the effects that the Federal Open Market Committee's (FOMC) September 2013 meeting, often referred to as the "untaper" meeting because plans for tapering were delayed, and the June 2021 "talking about talking about tapering" meeting had on the market's expectations for the future path of the fed funds rate. We show that a market response similar to 2013 has already occurred in the sense that an increase in the 10-year Treasury rate coincided with market participants expecting an earlier liftoff from a fed funds rate of zero. Subsequent taper talk only marginally affected how the market expects the pace of rate hikes to proceed. In other words, the market responds to increasing Treasury rates by first pricing in a strong opinion about how much time will pass before the first rate hike. Subsequent discussions about tapering have little to no effect on the market expectations for future interest rate policy.
For our analysis, we use the Federal Reserve Bank of Atlanta's, Market Probability Tracker (MPT), to measure the market's expectations for the future course of monetary policy. The MPT is computed and reported every day on the Federal Reserve Bank of Atlanta's website and is described in detail in an Atlanta Fed "Notes from the Vault" post. The MPT uses options contracts on Eurodollar futures to estimate the market's assessment of the target ranges of future effective fed funds rate. Using derivative contracts on Eurodollars has one main advantage over studying the effective fed fund futures directly. Unlike the futures market for fed funds, the options on Eurodollar futures market is one of the most liquid in the world, with a wide collection of traded options. Moreover, Eurodollar futures deliver three-month LIBOR (or London Interbank Offered Rate), which bears a stable relation and high correlation with the effective fed funds rate in global overnight money markets. Together, these features allow the MPT to extract more confidently measures of market expectations of future effective fed funds target ranges.
Turning our attention first to 2013, we look at how the market's expectations for the future path of rates changed as taper talk began to heat up. In figure 1, we plot several of the MPT's daily expected fed funds rate paths from before and after June 2013. Each unlabeled path in the figure is represented by a transparent blue line of the market expectations for the fed funds rate path as of Wednesday of that week. These weekly expected rate paths began on May 1, 2013, and ended on December 18, 2013, when the Fed announced it would begin paring down its asset purchases.
Note: Expectations computed daily with option data on Eurodollar futures contracts from May 1, 2013, to December 18, 2013. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the indicated week.
The orange line in figure 1 represents the market expectations as of May 1, 2013. At that time, no substantive discussion about the Fed shrinking its asset purchases had taken place. The FOMC had just released a statement that it would continue to purchase assets "until the outlook for the labor market has improved substantially in a context of price stability." Regarding its interest rate policy, the Committee stated that it "expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens." Given the Fed's policy, along with the state of the economy, the market expected the first rate hike to be in mid- to late 2015.
Between May 2013 and the next FOMC meeting on June 19, 2013 (the dashed blue line in figure 1), the market's expectation for future monetary policy began to price in an earlier rate hike sometime between late 2014 to early 2015 (see the sequence of transparent blue lines in figure 1 that move up and to the left from the orange to the dashed blue line). During this period between FOMC meetings, Ben Bernanke, then chairman of the Board of Governors, testified to Congress that the FOMC "could in the next few meetings...take a step down in our pace of purchases" (Bernanke Q&A congressional testimony, May 22, 2013).
Bernanke's May 2013 testimony may have contributed to pulling forward market expectations for when the Fed would end its highly accommodative monetary policy since many expected the Fed's asset purchases to end before the fed funds rate was increased from its zero lower bound. The chair's testimony is also credited with setting off what is commonly referred to as the "taper tantrum" in the Treasury market. In figure 2, the blue line shows how much the 10-year Treasury rate had changed since May 1, 2013. According to this figure, Bernanke's testimony was certainly followed by an increase in the 10-year Treasury rate, but this increase continued a trend that began back in May 2013. And market participants had been pricing in an earlier and earlier liftoff date while the 10-year rate was increasing in May, not when the chair testified to Congress.
Note: The blue line represents the change from May 1, 2013, to February 24, 2015. The orange line represents the change from November 5, 2020, to August 27, 2021.
The Committee's June 2013 statement on monetary policy changed little from its May statement, but the expected path for the fed funds rate had already steepened (compare the dashed blue line with the orange line in figure 1). Notably, it was over the six days that followed the June FOMC statement that the 10-year Treasury increased by 40 basis points (see the blue line in figure 2). Many believe this increase in the 10-year rate was due to Bernanke's comments during the post-FOMC press conference when, in responding to a question about asset purchases, he said it would be appropriate to moderate purchases "later this year" and to end purchases "around midyear" 2014. However, for our purposes, we point out the muted impact Bernanke's answer had on the expected rate paths plotted in figure 1.
Over the next couple of months, changes in the fed funds rate path continued to be minimal even in response to Bernanke's attempt to calm other markets by assuring market participants the Fed was committed to a highly accommodative monetary policy. By the September FOMC meeting—a meeting sometimes referred to as the "untapering" meeting because the Committee decided to "await more evidence that progress will be sustained before adjusting the pace of its purchases"—the expected funds rate path was statistically indistinguishable from the June rate path (see the dashed black line in figure 1). However, the September announcement to delay the tapering of its purchases appeared to have caught bond investors by surprise. In figure 2, we see that the 10-year Treasury rate (the blue line) dropped by approximately 20 basis points over the coming weeks—all while the market's expectation for the timing of liftoff remained relatively constant.
Over the rest of 2013, the pace of the expected rate hikes stayed relatively stable. Figure 1 shows this stability by the similar curvature of the expected path lines from September to December. Interestingly, the December FOMC formal announcement that the Fed would begin to reduce its monthly purchases of Treasuries and mortgage-backed securities (MBS) by $5 billion each did not change the market's expectations for how long it would be before liftoff (see the solid black line in figure 1). We interpret this as market participants having formed their expectations about the future pace of interest rate hikes when the Treasury rates had increased and as policymakers were beginning to talk about tapering and not when the Fed announced the actual date and pace of its shrinkage in asset purchases.
Now compare figure 1 to the sequence of expected rate paths plotted in figure 3 for the time interval of November 5, 2020, to August 11, 2021. Early in this time period, the orange line in figure 2 shows the 10-year Treasury rate increasing 95 basis points from November 2020 to the end of March 2021 (the high point of the orange line in figure 2). This increase in the 10-year rate was due in part to the improving economic conditions and optimism around the advent of COVID-19 vaccines. This time period also corresponds with a steepening in the market expectations for the fed funds rate path seen in figure 3. The "lower for longer" policy of the Fed can be seen in the flat November FOMC rate path (compare the orange rate paths in figures 1 and 3). But as in figure 1, the expected rate paths in figure 3 gradually steepen while the 10-year rate is increasing.
Note: The fed funds rate path was computed from daily option data on Eurodollar futures contracts from November 5, 2020, to August 27, 2021. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the week
The minutes from the April FOMC were released to the public on May 19, 2021 (see the pink rate path in figure 3). These minutes describe several participants suggesting that "it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases." Discussion about shrinking the monthly purchases of assets continued into the June 2021 FOMC meeting. Importantly, at the June FOMC press conference, Fed chair Jerome Powell responded to a question about the timeline for reducing asset purchases by saying that people can think of the June meeting as the "talking about talking about" meeting.
The market's expectation about the fed funds rate path to this taper chatter was muted. Market expectations for the first rate hike had already moved up from the middle of 2024 to the first half of 2023. Given the similarity in the paths at the FOMC meetings in June (see the dotted black line in figure 3) and July (the dashed black line in figure 3), and after Chair Powell's Jackson Hole speech (the solid black line), market participants did not alter their expectations about liftoff. Not even the June FOMC's hawkish Summary of Economic Projections affected the views of market participants on the future course of interest rates.
Comparing the sequence of 2013 and 2020–21 rate paths plotted in figures 1 and 3, we might believe that those who think tapering in 2021 will lead to a similar market reaction as in 2013 are right—but only in the sense that both events corresponded to a sizeable increase in the 10-year Treasury rate and not the actual taper.
That being said, after the rate paths in figures 1 and 3 steepened, the limited impact that taper talk had on the rate paths lends support to those who expect tapering to be a nonevent. The relatively constant pace of expected rate hikes found in 2013 and 2021 suggests that a formal announcement by the Fed on reducing its purchases of Treasuries and agency MBS will likely have a limited effect on the market expectations for the pace of future rate hikes. This is especially true for the 18- to 24-month time horizon of the rate paths.
Regardless of whether we believe that there will or will not be a "taper tantrum" similar to the one in 2013, the market expectations calculated from the Eurodollar futures market clearly show two common effects from the events of 2013 and 2020–21. The first is that as the 10-year Treasury rate begins to rise, market participants expect the Fed to start raising the fed funds rate earlier than before. The second effect is that after the first effect, the expected pace of future rate hikes does not appear to be very responsive to taper talk. Hopefully, knowledge of these tapering-related empirical regularities will help market participants form more accurate predictions about future interest rate policies.
May 27, 2021
The Role of Central Banks in Fostering Economic and Financial Resiliency
The Atlanta Fed recently hosted its 25th annual Financial Markets Conference, with the theme of Fostering a Resilient Economy and Financial System: The Role of Central Banks. The conference addressed both the adequacy of the monetary policy toolkit and the role of the U.S. dollar (USD) in international financial markets. The conference included two keynote talks. The first day featured a keynote speech by Federal Reserve Board vice chair Richard Clarida, followed by a discussion with Atlanta Fed president Raphael Bostic. The second day began with an armchair discussion featuring Harvard professor Larry Summers and Atlanta Fed research director David Altig. A video of the conference is available here . This post reviews some of the highlights from the conference.
Vice chair Clarida's keynote speech focused on global factors that help determine the yield curve for sovereign bonds. Clarida observed that studies of domestic and major foreign government markets have found that most of the movements in the term structure of interest rates can be explained by the overall level of the curve and the slope of the curve. He then reviewed work suggesting that a global factor—one that is highly correlated with estimates of the neutral real interest rate—has a great influence on the level of the curve. Given this information, central banks may not have much ability to influence the yield curve's level unless they are willing to unanchor inflation expectations in their domestic market. Clarida then presented evidence that the slope of the U.S. yield curve is highly correlated with its monetary policy, specifically the deviation of the U.S. neutral nominal policy rate from the actual federal funds rate. He acknowledged that correlation does not equal causation but provided some evidence that central bank decisions (by the Fed and major foreign central banks) have a causal relationship with the slope of the yield curve. These observations led Clarida to conclude that "major central banks can be thought of as calibrating and conducting the transmission of policy...primarily through the slopes of their yield curves and much less so via their levels."
Professor Summers raised a variety of concerns about current policy and the risks to the financial system in his chat on the conference's second day. One of these concerns relates to the monetary policy projections, which suggest that inflation will remain sufficiently low so that the Fed's policy rate may not increase for several years. This expectation of low rates may create a "dangerous complacency," according to Summers, that will make it more difficult to raise rates. The result may be that nominal policy rates remain too low, producing higher inflation that leads to even lower real rates and even higher inflation. The result could be not only a "substantial pro-cyclical bias in financial conditions" but also a threat to financial stability if the low nominal rates result in excessive financial leverage.
Monetary policy panel session
The monetary policy toolkit received some scrutiny in a panel titled "Is the Monetary Policy Toolkit Adequate to Meet Future Challenges?" It was moderated by Julia Coronado, president of MacroPolicy Perspectives. Coronado promised a session with some provocative comments, and each of her panelists delivered. Among the problems addressed by the panelists was central banks' limited ability to counteract economic downturns. Historically, central banks have lowered their nominal interest rate target by several percentage points in response to the onset of a recession, or even the elevated risk of one. The continuing decline in nominal rates, however, has reduced central banks' ability to use rate reductions to fight recessions, instead forcing them to rely more on quantitative easing (or more accurately, large-scale asset purchases). Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics, and Willem Buiter, a visiting professor at Columbia University, provided two alternative ways of restoring the central bank's ability to lower nominal rates by more than 1 or 2 percentage points.
Gagnon's analysis was based on the Fisher equation, in which the nominal interest rate is approximately equal to the real rate of interest plus the rate of inflation. Gagnon observed that central banks, including the Fed, had set a target inflation rate of 2 percent back when the equilibrium real rate was higher (likely around 2 to 3 percent). Establishing this target rate resulted in equilibrium nominal interest rates around 4 to 5 percent, which gave central banks considerable room to respond to a recession. However, in the period since the inflation targets were set, equilibrium real rates have fallen by 1 to 2 percentage points. This decline greatly reduced central banks' ability to lower rates without taking them negative. Thus, to restore the ability of central banks to respond to higher inflation, Gagnon argued that central banks' inflation target should be increased to 3 to 4 percent.
Buiter implicitly started from the same point: that the decline in the equilibrium real rate had left central banks with too little room to cut interest rates. However, rather than raising the inflation target, Buiter argued that a better solution would be to accept deeply negative nominal interest rates. Several central banks in Europe, as well as the Bank of Japan, have lowered their rates below zero but never as much as 1 percent below zero. Buiter recommended that central banks take the steps necessary to be able to have deeply negative interest rates if that is appropriate for conditions.
Simon Potter, vice chairman at Millennium Management, noted an international dimension to the Fed's policy setting. Potter observed that many emerging markets had taken on considerably more debt to respond to the ongoing pandemic. He argued that these countries would need fast U.S. growth, and the accompanying increase in exports to the United States to be able to service their debt. Absent such increased debt service capacity, he pointed out that changes in the structure of these countries' debt markets would make rescheduling their debts even more difficult than it had been previously.
These provocative comments did not go unchallenged, however, as the other panelists raised concerns about the feasibility and/or desirability about each of these policy recommendations in the subsequent discussion that Coronado moderated.
Global dollar policy session
A panel on the conference's second day had the provocative title "Is the Financial System's Backbone, the U.S. Dollar, Also a Transmitter of Stress?" The panel's moderator was Federal Reserve Bank of Dallas president Robert Kaplan, who began the discussion by highlighting the importance of the USD in both international trade and international financial markets.
Stanford University Professor Arvind Krishnamurthy's presentation supplied further evidence on the importance of the USD in trade and financial markets. He suggested that the USD's important role resulted in it providing a convenience yield to its users, which resulted in lower USD interest rates for those borrowing USD—both domestic and foreign borrowers. These lower rates, however, came with some financial risks, according to Krishnamurthy. For one, lower rates may induce greater financial leverage in U.S. borrowers. Additionally, foreigners who borrow USD to take advantage of the lower rates may be creating a mismatch between the currency they receive as revenue (especially from sales in their domestic markets) and the USD they need to repay their debt.
Thomas Jordan, chairman of the governing board of the Swiss National Bank, also noted the dominance of the USD in international markets and discussed its implications from the Swiss point of view. He noted two ways in which Switzerland is especially vulnerable to developments regarding USD. First, Swiss banks hold substantial amounts of USD assets and liabilities. Second, the Swiss franc is a safe haven currency that experiences increased demand in times of international financial stress. These result in Switzerland having a strong interest in global financial stability and especially in the stability of USD-funding markets. In this respect, Jordan observed that the Federal Reserve's swap lines with other central banks, including the Swiss National Bank, has been "very crucial." The swap lines provide an important liquidity backstop that recently proved valuable during the COVID-19 crisis.
Michael Howell, the managing director at CrossBorder Capital, focused on the potential for another currency to displace the USD in international markets. In his presentation , he argued we should not be "shortsighted" in dismissing other currencies. In particular, he pointed to China, saying that China sees the USD as a rival and wants to displace it, particularly in Asia. He then went on to discuss some of the steps that China would need to take—and is taking—to displace the USD.
After these remarks by the panelists, Kaplan moderated a question-and-answer session that took a closer look at these and other issues.
- Business Cycles
- Business Inflation Expectations
- Capital and Investment
- Capital Markets
- Data Releases
- Economic conditions
- Economic Growth and Development
- Exchange Rates and the Dollar
- Fed Funds Futures
- Federal Debt and Deficits
- Federal Reserve and Monetary Policy
- Financial System
- Fiscal Policy
- Health Care
- Inflation Expectations
- Interest Rates
- Labor Markets
- Latin AmericaSouth America
- Monetary Policy
- Money Markets
- Real Estate
- Saving Capital and Investment
- Small Business
- Social Security
- This That and the Other
- Trade Deficit
- Wage Growth