Oh my, how things have changed since late last year.
New York Fed President William Dudley, one of the big and influential doves on the policy setting FOMC, drove home the point today when he said at a roundtable discussion that the economic outlook was “pretty good,” and that he wasn’t seeing too much of a signal in the low bond yields.
Longer-term yields have caused a lot of gray hairs. While short-term yields have risen in response to the Fed’s rate hikes since December, longer-term yields have actually fallen since then – a sign that the bond market doesn’t believe the Fed’s current projections of four more rate hikes over the next two years, which would bring the Federal funds rate target to a range between 2.0% and 2.25%. By contrast, the 10-year yield is 2.18%.
Though low, those longer-term yields are still relatively high compared to the near-zero yields in Europe and Japan, he said. The Fed will have to keep raising rates at a gradual pace in order to avoid having to raise them so sharply in the future that it might trigger a recession, he said.
Dudley and the “suddenly hawkish” Yellen, as she has come to be called, are walking in lockstep. At its meeting last week, the FOMC has raised its target for the federal funds rate for the third time since December, like clockwork at every other meeting, to a range between 1% and 1.25%. The Fed has penciled in one more rate hike this year, and several more over the next two years.
In addition, it has now put in place a plan to unwind QE, starting “this year,” possibly as early as September, which will have the opposite effect of QE.
QE was designed to bring down long-term yields and mortgage rates and inflate asset prices across the spectrum. It worked like a charm. Unwinding QE – “balance sheet normalization,” as the Fed calls it – will do the opposite.
Gone is “flip-flop Fed” of 2015 and 2016. This Fed is on a mission. It has a plan. There is little dissent within the Committee on rates and no dissent on reversing QE. They’re moving forward. It is a tightening cycle like no other before. In prior tightening cycles, the Fed raised its target for the federal funds rate. This time around, it’s also reversing QE.
The Fed heads don’t even expect a great economy, just the same lousy economic growth we’ve had for years, with median projections of 2.2% in 2017, 2.1% in 2018, 1.9% in 2019, and 1.8% in the “longer run.” Since late last year, slow growth is no longer an excuse for loose monetary policies.
And the tightening cycle will continue – that’s what Dudley in essence said. The Fed isn’t going to be sidetracked by quivering economic data. This includes inflation, which came in lower than the Fed had wanted, but Yellen made a special effort to explain it away [Why “Suddenly Hawkish” Yellen Brushed off the Dip in Inflation].
And today, Dudley marched in lockstep with Yellen. He pointed out, according to The Wall Street Journal, that slowing inflation and signs of a slowing economy haven’t caused any worries. He was “very confident” that there is “quite a long ways to go” in the third-longest economic expansion in US history.
Something changed at the Fed no later than September last year, when another dove, Boston Fed governor Eric Rosengren, floated the idea of unwinding QE, and no one at the Fed tried to shoot down the idea!
He has been fretting since 2015 about the commercial real-estate bubble in the US, and the damage its $4 trillion in loans could do to banks, particularly the smaller lenders that are so heavily exposed to it. Collapsing collateral values of CRE were a big factor in the Financial Crisis. This time around, the new CRE bubble is far bigger.
That isn’t the only asset bubble the Fed is worried about. Since assets are so highly leveraged, any major decline in prices (collateral values) can wreak havoc on the financial system. So the Fed wants to engineer a soft landing for asset prices, rather than let this get out of hand completely. And the Fed will continue to tighten until its gets some kind of landing by the markets.
But the record of Fed-engineered “soft landings” isn’t good. The Fed is very reliable when it comes to inflating asset prices. But soft landings? The last two tightening cycles and attempted soft landings ended in crashes: the dotcom bust and the Financial Crisis.
Now the Fed has created an another array of bubbles and is belatedly fretting about them. But this time, it’s different. This time, the bubbles are even more magnificent than those leading to the prior two “financial events.”
So the Fed laid out its plan to unwind QE by $600 billion a year. The markets shrugged. That’s how it usually is. But “painful sell-offs eventually materialize.” Read… Markets Blow off the Fed until Next “Financial Event”