Normalization Versus Rate Hike Policy
The steadfast Federal Reserve is at it again. After a meeting on November 2nd, the committee of ten concluded with the federal funds rate and the discount rate held steady at the status quo. In the release, they say that “the case for an increase in the federal funds rate has continued to strengthen,” but of course, confidence wasn’t strong enough for the economy to off of low-interest rate life support. Three hesitant words stuck out to in particular: the labor market is expected to “strengthen somewhat further,” economic activity well grow “at a moderate pace,” and market risks “appear roughly balanced.” To me, these filler words indicate that the Federal Reserve recognizes the signs of a cyclical peak and seeks to diffuse tension in an economy that is moving flatly. The S&P 500, Dow Jones Industrial Average, and Nasdaq indices are trending at all-time highs, valuations continue to rise, and economic numbers paint an ambivalent picture of the economy. It’s not hard to conclude that we’re reaching a cyclical top after considering the fact that a seven-year bull market has pushed us to this top.
During a bull market, central banks typically raise interest rates to keep in check a rising level of inflation, but the Great Recession lead to a recovery that suggested typical monetary policy should be abandoned. Instead, policies like global quantitative easing and cheap debt were held in place to support a recovery. A divergent strategy has forced the Federal Reserve, along with the rest of the world’s central banks, into uncharted waters where it elected to keep the status quo. Companies liked that, but weird things started happening with inflation. An oil price shock caused half the world to develop symptoms of deflation, and rate hikes in this scenario would only hurt world markets.
Needless to say, the Federal Reserve finds itself in a very “un-normal” position where it must protect investors from a bubble while also shielding the economy from deflationary pains. In order to do this, the FOMC committee has elected to move in the direction of a “normalization” policy. When I first heard this term from one of the Fed member’s speeches, I just assumed “normalization” meant “rate hike,” but there is a distinction between the two that the Fed has intentionally signaled. While both involve increasing interest rates, a rate hike policy has a bearish connotation that suggests an abrupt shift in rates while normalization implies a more neutral move towards a clear target indicated by the central bank.
The key driver of the use of “normalization” language is the lapse in the recovery of inflation after the Great Recession. The chart above shows how a series of three periods of quantitative easing lead to a decline in the inflation rate from 3.77% annually in 2011 to -0.20% in early 2015. The FOMC first signaled that inflation was not where it wanted to be in the release following the December 2012 meeting by saying, “Inflation has been running somewhat below the Committee’s long-run objective.” Ever since then, the issue of inflation has risen to the top of the Fed’s list of priorities and has consistently been the reason why rates were held low. “Normalization” is the “solution” to this problem of nagging deflationary pressures, and I say “solution” carefully because this policy only works if markets respond the right way.
As evidenced by USD and Treasury yield movements at the conclusion of an FOMC meeting, investors like to jump the gun when it comes to reacting to a monetary policy updates. Normalization seeks to avoid the volatility associated with these movements, so the Fed acts in an extremely slow manner. In fact, they will set medium-term plans for the next three year and purposely act slower than what they projected. For example, projections from the December 2015 meeting suggested that four rate hikes would be a plausible way to move forward in 2016. Seven out of eight meetings later, the Fed has yet to raise even rates even once. In doing this, the Federal Reserve is manipulating expectations so that investors trade like four rate hikes are in play. When the meetings actually do come around, expectations are gradually dropped and the markets perceive the lack of rate hikes as accommodative policy. When rates are increased in December 2016, the markets’ reaction shouldn’t be decisively bearish. “Rate hike” policy suggests that markets should expect a rise in interest rates, and the Federal Reserve will follow through on these intentions. This distinction is necessary if a 2 percent inflation target is to hold any legitimacy. Only through normalization policy could the Federal Reserve massage inflation rates to their liking; a clear rate hike agenda is deflationary and would yield different results.
An agenda that is contractionary on purpose would be very dangerous in the current global monetary condition where central banks across developed and emerging economies have failed to move in a coordinated manner. The BIS released the charts above showing how central banks have been forced to respond to local inflationary effects. In Europe and Japan, negative yields have been introduced to combat stagnate growth and deflation while developing countries like Brazil, Colombia, South Africa, and India have set rates higher to tame inflation rates above the respective bank’s inflation target. This environment differs drastically with the coordination that was required to repair the damage of the financial crisis. If the Federal Reserve chooses a “rate hike” policy which could upset measures being taken in countries troubled by deflation, it could send negative shockwaves in the foreign exchange and capital markets. Adopting “normalization” would put the Federal Reserve more in line with foreign central banks who are attempting their own forms of careful normalization, and consequently, would calm volatility in equity and bond markets that is being caused by shifting investor expectations.
The Federal Reserve has shown its preference for normalization policy by choosing the appropriate signaling and maintaining global monetary coordination. Going forward, the Fed will deviate farther from rate hike policy by ensuring that the differences in timing are evident. In May 2015, BBVA published some interesting research on timing differences in normalization and tightening (rate hike) policies. A comparison of “past tightening cycles” shows that the length of low rates and the expected length of tightening period is projected to surpass the five other cycles that have occurred in the past 35 years. According to basis point per month calculations, this cycle of “tightening” will occur 31 percent slower than the slowest cycle in 1999. These numbers were published in 2015, and since then, the actual rate of increase has been about 1.3 basis points per month. Even if the Federal Reserve had held to its policy projections in December 2015 (25 basis point increase in Dec 2015 and four 25 basis point increases in 2016), the basis point per month increase would be 6, significantly lower than what investors expected at the time of this paper’s publication.
With such a clear difference in the uptrends of these tightening cycles, it seems clear that the Federal Reserve is trying to implement a different policy framework. BBVA even identified this shift toward tightening suggesting that “’normalization’ is defined as an increase in the Fed funds rate at a point when monetary policy could be assessed as loose.” Even if Janet Yellen and her FOMC cohorts have successfully aligned expectations, coordination, and timing with a policy considered “normalizing,” can we be sure that it will work?
There’s really no way to tell. Markets only have one rate hike under their belt, and that instance led to a sell-off at the beginning of 2016 that threatened to turn into a full-on bear market. Expectations say another 25 basis point rate hike is in the cards for December, so will a similar reaction greet 2017? Once again, it’s a toss-up. One year ago oil prices were significantly more volatile, but the UK had not left the European Union. Growth rates in the United States appear to have stabilized with the most recent GDP figure of 2.9 percent surprising positively, but the Eurozone and Japan had sunk deeper into negative interest rates. The economy is no replica of what it was a year ago, but only a few structural shifts make it distinct.
As far as predictions go, I see a rate hike in December confirming the Federal Reserve’s commitment to “normalization” rather than “rate hike” policy. In that meeting, it will project another three or four 25 basis point rate hikes in 2017, but, like in 2016, that will be an overshoot of its actual path. If markets respond bearishly to the December hike (like this year), the Fed might squeeze in two 25 basis point but one is more likely. If the economy shows improvement and earnings season at the end of 2016 isn’t a total bust, we might see two to three rate hikes. However, the amount of rate hikes in 2017 will always be at least one less than what is projected. This is essential in case the FOMC committee needs to pull out a “bullish surprise” of holding out one meeting so as to avoid any contractionary moves.