QE unwind in September, “another rate hike later this year.”
The media have been talking themselves into a lather about how the less-than-2% inflation would force the Fed to stop hiking rates. But William Dudley, president of the New York Fed and one of the most influential voices on the policy-setting Federal Open Markets Committee (FOMC), just dropped a stunning bombshell about low inflation – why it might be low and how that “actually might be a good thing.”
The kickoff for unwinding QE appears to be in the can. There’s unanimous support for it on the FOMC. It appears to be scheduled for the September meeting. The market has digested the coming “balance sheet normalization.” Stocks have risen and long-term yields have fallen, and financial conditions have eased further, which is the opposite of what the Fed wants to accomplish; it wants to tighten financial conditions. So it will keep tightening its policy until financial conditions are tightening.
QE was designed to produce the “wealth effect,” as Bernanke himself explained it to the public, where those with assets get wealthier and then spend some of that wealth in the real economy. Part one worked. Part two didn’t. Now the experiment is over and will be partially unwound. Asset holders are requested to hang on – that’s the message.
In his interview with the Associated Press (transcript), Dudley confirmed this. As the Fed allows its portfolio to “run down,” he said – dropping about $2 trillion of securities over the next few years – “the private sector has to absorb somewhat larger amounts of Treasury securities and agency mortgage-backed securities, that will probably put some modest upward pressure on long-term yields.”
So bond prices, which move in the opposite direction of yields, are going to decline. But no biggie; bond holders had it so good for so long.
And rate hikes?
He expects the economy to keep muddling through with growth at “around 2%.” He said, “We’re still on the same trajectory we’ve been on for several years.” This growth is “sufficient to continue to tighten the labor market.” While inflation is “somewhat below our objective,” he expects “to see firmer wage gains, and that will ultimately filter into inflation moving up towards our 2% objective,” but “it’s going to take time.”
However, that below-objective inflation may not stop the rate hikes:
“Now the reason why I think you’d want to continue to gradually remove monetary policy accommodation, even with inflation somewhat below target, is that:
“One, monetary policy is still accommodative, so the level of short-term rates is pretty low, and
“Two — and this is probably even more important — financial conditions have been easing rather than tightening. So despite the fact that we’ve raised short-term interest rates, financial conditions are easier today than they were a year ago.
“The stock market is up, credit spreads have narrowed, the dollar has weakened, and those have more than offset the effects of somewhat higher short-term rates and the very modest increases that we’ve seen in longer-term yields.”
If the economic forecast evolves “in line” with his expectations, he said, he “would be in favor of doing another rate hike later this year.”
In other words, the market’s reaction to the Fed’s action – that stocks and bonds have risen and that spreads have narrowed since the Fed has started tightening, which is the opposite of what the Fed wants to accomplish – is a primary reason for further tightening. Low inflation, no problem.
That rate hike “later this year” would be at the December meeting, after kicking off the QE unwind at the September meeting. In this cycle, the Fed has only made policy changes at meetings that were followed by a press conference. The September and December meetings are the only such meetings left this year. The Fed is sticking to its plan.
Then he was challenged on inflation, which has been below the 2% target for a long time. What should the Fed do?
“So, I think the jury’s out of whether there is sort of structural, secular changes in place that are holding inflation lower on a sustained basis,” he said. And these changes have to do with the internet economy where price comparisons are instantly possible and the environment has become very price competitive:
“The distribution methods of how goods and services are provided have changed pretty dramatically. So this — and I think that’s probably eroding pricing power and brand loyalty. It’s possible that that could be putting downward pressure on inflation.
“But if that’s the case, that’s not really a bad thing. That means we can actually allow the economy to operate at a higher level potentially of resource utilization.
“So, I think the jury is out, whether this lags or is just going to take some time for it to show through, or whether we’re in a different regime.”
He mentioned “the big decline” in cellphone services prices which the suddenly hawkish Yellen had listed in June as a cause for the recent softening of inflation, but there could be “something more fundamental going on” too – such as the internet economy that forces companies into more open price competition.
“So, if there are these secular forces that are pushing inflation lower, perhaps we can actually go to a somewhat lower unemployment rate. I would actually view – rather than people wringing their hands that this is so awful that inflation is low, it actually might be a good thing because it could allow you to run the economy at a little bit higher level of resource utilization, which I think would be good.
“People get employed, they get job skills, they’d be able to build their human capital over time. The productive capacity of the U.S. economy would be greater. All those things would be good things.”
Yes, the benefits of low inflation. Dudley finally discovered them.
When Dudley, one of the most influential members of the FOMC, begins airing something like this in public, it likely means that discussions at the FOMC are tilting this way, that there might suddenly be a recognition that technological improvements and efficiencies should lead to lower prices in some areas, though not all areas, and that an overall inflation rate that’s lower than 2% would be a “good thing,” for all the reasons Dudley specified, plus some.
Yellen has also pointed at the sharp drop in prescription drug prices as a cause of low inflation. This too is a “good thing,” as Dudley might say. But it caused a bloodbath among pharmaceutical companies after the government cracked down on price fixing efforts. Read… Pharma Shares Melt Down, But Consumers Might See Relief