What is New on the Macro Level? By Hubert Marleau, Palos Mgt. Montreal
A Long Way Off From Normalization The roles of interest rates are manifold. The crucial ones are:
1) Ensure that scarce resources are put to their highest use by juggling interest sensitive cyclical expenditures to an optimum level;
2) Compensate savers for sacrificing immediate consumption and
3) Regulate the discount rate used to value the long term utility rate of durable goods and return rate on investments.
There is plenty of evidence suggesting that the US monetary authorities would like to move the
Federal funds rate, in time, closer to a secular neutral policy rate.
The concept of a neutral policy rate has a specific meaning in modern economic jargon. A neutral rate is one that is consistent with full employment and with an ongoing and expected inflation rate equal to the Fed’s inflation target.
Unfortunately, the neutral policy rate is time-varying because macroeconomic sentiment can have either an inflationary or deflationary bias. In this connection, the market for two-year treasuries could be good place to start because there is sufficient expectation in them to reflect where the bias lies.
Thus, if the neutral policy rate can be construed as a secular reference point, actual policy rate deviations from the neutral rate could be used to see if the monetary stance is easy, even keel or tight.
In our judgment, the new nominal neutral rate is 2.25% and not the old Taylor rule assumption of a neutral 4% nominal rate. It is also our opinion that the secular neutral policy rate equals the ten year average real yields on two year treasuries (about 25 bps) plus the Fed’s inflation target of 2.0%.
The Fed’s current target rate is far below Palos’ estimated nominal neutral rate of 2.25%, the interest sensitive cyclical expenditures to GDP is above 25% and the Palos Monetary Policy Index of more than 100 points. These all dictate that short term interest rates should be hikes. Yet, the Federal Reserve said on Wednesday it would be patient about raising them in the coming year.
The FOMC admitted confidence in strong US growth; but it decided to be prudent and patient for there is too much deflationary pressure coming from the rise in the US dollar, the weakening international economy and falling oil prices. Indeed, the median conjecture among the monetary officials put the target rate at 1.125% by the end of 2015. At which time an even keel neutral policy would not have taken hold.
On this basis, it appears that investors shall continue to experience an easy monetary stance for a very long time. The Economist put it simply in this week’s magazine. What could be better than an economy converging on full employment? A central bank in no mood to get in the way.
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